Photo by Etienne Martin on UnsplashThe New York Federal Reserve said on Tuesday, September 5, 2023, that the estimate for the neutral rate for Q2 has eased to 0.57 percent from 0.68 percent in Q1. Analysts typically translate that rate into a real-world setting by adding the neutral rate to the Fed’s 2 percent inflation target. The current reading suggests that a federal funds rate of around 2.5 percent would represent a neutral setting. Given that the Fed’s current target rate range is between 5.25 and 5.5 percent, this suggests that the interest rate policy remains very restrictive.Based on this, it is quite likely that the Fed will loosen its interest rate stance ahead. This view is further reinforced by the massive increase in the ratio of the federal funds rate target to the neutral rate of 9.2 in Q2 this year from 0.2 in Q4 2021.By popular thinking, the neutral rate is one that is consistent with stable prices and a balanced economy. Hence, in order to attain economic and price stability, Fed policymakers should navigate the federal funds rate toward the neutral rate range.In the late nineteenth century, the Swedish economist Knut Wicksell articulated this framework, which has its origins in the eighteenth-century writings of the British economist Henry Thornton.In fact, it is safe to suggest that the current framework of central bank operations throughout the world is based to a large degree on Wicksell’s writings. Now, if what we are suggesting is correct, then the obvious key to understanding the rationale of the actions of the central banks would be the writings of Knut Wicksell. The Neutral Interest Rate FrameworkAccording to Wicksell, the neutral rate is

a certain rate of interest on loans which is neutral in respect to commodity prices, and tend 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 natural rate of interest on capital.

In this way of thinking, the neutral rate of interest is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.According to the neutral rate framework, the main source of economic instability is when the money market interest rate is not in line with the neutral rate. In Wicksell’s framework, only money affects the price level. However, the effect of money on the price level is not direct. It operates via the gap between the money market interest rate and the neutral rate. The mechanism works as follows: If the market rate falls below the neutral rate, investment will exceed savings, implying that aggregate demand will be greater than aggregate supply. Assuming that the excess demand is financed by the expansion in bank loans, this leads to the creation of new money, which in turn pushes the general level of prices up. Conversely, if the market rate rises above the neutral rate, savings will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall. Hence, whenever the market rate is in line with the neutral rate, the economy is in a state of equilibrium, and there is neither upward nor downward pressures on the price level.According to Wicksell, “If it were possible to ascertain and specify the current value of the natural rate, it would be seen that any deviation of the actual money rate from this natural rate is connected with rising or falling prices according as the deviation is downward or upward.”Furthermore, Wicksell maintained that—to establish whether monetary policy is tight or loose—it is not enough to pay attention to the level of money market interest rates, but rather one needs to contrast money market interest rates with the neutral rate.Thus, if the market interest rate is above the neutral rate, then the policy stance is tight. Conversely, if the market rate is below the neutral rate, then the policy stance is loose. Again, according to Wicksell, whenever the money market rate is in line with the neutral rate, the economy is in a state of equilibrium, and there are neither upward nor downward pressures on the price level.Note that, in the mainstream framework, the neutral interest rate is formed at the point of the intersection of supply and demand curves. The supply and demand curves as presented by mainstream economics originates from the imaginary construction of economists. None of the figures that underpin these curves originate in the real world; they are purely imaginary. According to Ludwig von Mises, “It is important to realize that we do not have any knowledge or experience concerning the shape of such curves.”Consequently, this implies that it is not possible to establish the neutral interest rate from the imaginary curves. How then can one tell whether the market interest rate is above or below the neutral rate? Wicksell Wicksell that policymakers pay close attention to changes in the price level. A rising price level would call for an upward adjustment in the interest rate, while a falling price level would signal that the interest rate should be lowered.Following the Wicksellian framework, once the gap between the money market interest rate and the neutral rate is closed, the central bank must actively ensure that the gap does not emerge again. In this framework, a monetary policy that maintains the equality between the two rates becomes a factor of stability. Most experts hold that once the Fed has managed to bring the federal funds rate to the neutral rate, then this must mean that the economy is in a state of equilibrium.In order to extract the unobservable neutral interest rate, economists employ sophisticated mathematical methods. However, does all of this make much sense?What the Fed is trying to establish is an interest rate that corresponds to the conditions of the free market. Obviously, this is in contradiction to the free market. In a free market in the absence of central bank monetary policies, the interest rates that emerge would be truly neutral. In a free market, no one would be required to establish whether the interest rate is above or below some imaginary equilibrium. Equilibrium in the context of conscious and purposeful behavior has nothing to do with the imaginary equilibrium as depicted by popular economics. Equilibrium is established when individuals’ ends are met. When a supplier is successful in selling his supply at a price that yields profit, he is said to have reached an equilibrium. Similarly, consumers who bought this supply have done so in order to meet their goals. Information Regarding the Neutral Rate Cannot Help Achieve StabilityEven if the Fed had the information of where the neutral rate should be, it will not be able to achieve economic stability. The reason is because the Fed will be forced to add or subtract money in order to keep the market rate in line with the neutral rate. This, however, will lead to boom-bust cycles and economic instability.Hence, there cannot be such a thing as a neutral interest rate policy that will result in economic and price stability. Rather than targeting the money market interest rate and moving it toward the unknown neutral rate by means of monetary tampering, which itself leads to more instability, a better alternative is to not intervene. In the absence of central bank monetary policies, the interest rates that emerge will be truly neutral. Summary and ConclusionThe whole idea of the neutral interest rate is unrealistic. What the Fed is trying to establish is an interest rate that corresponds to the conditions of the free market. Obviously, this is in contradiction to the free market since, in a free market, there is no central bank setting the interest rate.More By This Author:October’s Sobering Jobs Report Adds To Mounting Bad Economic News The Current U.S. Economic Situation From An Austrian Viewpoint How German Exports Lost The Race With China