Why the Neutral Interest Rate Cannot Be Established

Most commentators are of the view that what prevents the attainment of price stability is the deviation of the policy interest rate, such as the federal funds rate, from the neutral interest rate, also known as the natural interest rate. The neutral interest rate, it is held, is the one that is consistent with stable prices and a balanced economy. According to this view, what is required is for Fed policymakers to successfully direct the federal funds rate toward the neutral interest rate.

It is believed that once the Fed brings the federal funds rate in line with the neutral interest rate, price stability and economic stability are likely to emerge. This is based on the writings of the Swedish economist Knut Wicksell in the late 19th century. The current framework for central banks throughout the world is based to a large degree on the writings of Wicksell.

Knut Wicksell’s Framework for Price Stability

The key of the Wicksell’s framework is the neutral interest rate, which Wicksell defined as,

A certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods. It comes to much the same thing to describe it as the current value of the neutral rate of interest on capital.

Hence, according to Wicksell and his followers, the neutral interest rate is the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.

In Wicksell’s framework, if the market interest rate falls below the neutral interest rate, investment will exceed savings, implying that the quantity of goods demanded will be greater than the quantity of goods supplied. Wicksell assumed that the excess in the quantity of goods demanded is likely to trigger an increase in bank loans and an increase in the stock of money. Consequently, the prices of goods will increase.

Conversely, if the market interest rate rises above the neutral interest rate, savings will exceed investment, the quantity of goods supplied is going to outstrip the quantity of goods demanded, bank loans and the stock of money will contract, and the prices of goods will fall.

Hence, whenever the market interest rate corresponds to the neutral interest rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level. Again, the deviations of the market interest rate from the neutral interest rate sets in motion changes in money supply and this, in turn, disturbs the general price level.

Wicksell held that to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of the market interest rate, but one should compare the market interest rate to the neutral interest rate. If the market interest rate is above the neutral interest rate, then the policy stance is tight. Conversely, if the market interest rate is below the neutral interest rate, then the policy stance is loose.

How is one to implement policy according to this view? The main problem here is that the neutral interest rate cannot be observed. How can one tell whether the market interest rate is above or below the neutral interest rate? Wicksell suggested that policymakers should pay close attention to changes in the price level. An increase in prices would call for an upward adjustment in the market interest rate, while a decrease in prices would signal that the market interest rate should be lowered.

The Real Interest Rate Cannot Be Ascertained

In a world without money, such as presented by Wicksell, would it be possible to establish the interest rate on the lending of present apples in return for potatoes in the future?

In a world without money, all that one could establish is the quantity of present goods exchanged for the quantity of various future goods. For instance, one present apple is exchanged for two potatoes in one year. Alternatively, one present shirt is exchanged for three tomatoes in one year. There is, however, no way to establish the interest rate that a lender of an apple receives from a borrower of this apple that repays the loan by means of potatoes.

It is not possible to calculate the interest rate on the loan since potatoes and apples are not the same goods. Only with the existence of money can the interest rate be established in a quantifiable form. The following example provides an illustration of the interest rate formation.

John the baker who produced the ten loaves of bread sells these loaves for $10. Now, according to his time preference John is ready to become a lender of the ten dollars in return for $11 in one year. Note that John the baker assigns a greater importance to the future $11 versus the present $10 otherwise he would not agree to become a lender of the 10 present dollars.

According to the time preference of Bob the shoemaker, he is willing to borrow $10 and repay $11 in one year. The shoemaker assigns a greater importance to the $10 in the present versus the $11 in one year. Hence, both John the lender and Bob the borrower are likely to agree to enter this financial transaction because they both expect to benefit from it.

Without the existence of money, the baker could not establish the quantity of future goods required by him that will equate with the interest rate of 10 percent. Only by means of money, can the monetary market interest rate be established. In the world without money, the interest rate cannot be established, it follows that the neutral interest rate cannot be established either. However, according to Wicksell, the neutral interest rate is established in the world without money.

Additionally, note that, according to Wicksell, the neutral rate is established as the rate at which the total demand for physical capital coincides with the total supply of physical capital. However, the total physical demand and supply of capital cannot be established since capital goods are heterogeneous and cannot be added to a meaningful total.

Consequently, it is not possible to separate the neutral interest rate from the market interest rate. We can thus conclude that economists’ and central bankers’ attempts to establish the neutral interest rate should be regarded as an impossible task. In a free market, without the central bank, no one would be required to establish whether the market interest rate is above or below the neutral interest rate.

Conclusion

The essence of the Fed’s thinking emanates from the ideas of the late 19th century writings of the Swedish economist Knut Wicksell. According to Wicksell, the key to economic stability is targeting the market interest rate to the neutral interest rate. It is, however, not possible to isolate the neutral interest rate. Consequently, policies that aim at reaching an unknown interest rate run the risk of promoting instability.