There’s a lot of talk these days about the so-called “neutral” (or “natural” or “terminal”) interest rate projections of the Federal Reserve. In fact, their projection of this number is a key argument in their ongoing decision to keep rates at historically very-low levels for what has been an extended period of time. (Specifically, Federal Reserve officials have argued that the neutral interest rate has sharply declined in recent years, meaning that apparently ultra-low interest rates do not really signify easy monetary policy.)
What is this neutral rate? The neutral rate, it is argued, is simply the federal funds rate at which the economy is in equilibrium or balance. If the federal funds rate were at this mysterious neutral rate level, monetary policy would be neither loose nor tight, and the economy neither too hot nor too cold, but rather just chugging along at its long-run optimal potential. The underlying theory is that loose monetary policy — where the Fed’s policy rate is set below the neutral rate — can temporarily stimulate the economy, but only by causing price inflation that exceeds the Fed’s desired target (which, by the way, eventually causes overheating and a crash). On the other hand, if the Fed is too tight and sets the policy rate above the neutral rate, then unemployment creeps higher than desired and price inflation comes in below target.
In short, the neutral interest rate is one where the central bank is not itself distorting the economy. Monetary policy would really be nonexistent, as the Fed would not be altering the interest rate resulting from a free market discovery process between borrowers and savers. (This of course raises the question, why do central planners need to fabricate something that would naturally exist in their absence?) This is near where Yellen actually thinks we are these days, hence she sees little urgency in raising rates and thus lessening what, on the face of it, looks like a very loose current monetary policy.
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The Theory of the Neutral or Natural Rate
Much of this neutral rate talk at the Fed is supposedly supported by the work of Swedish economist Knut Wicksell (1851–1926), who argued that the “natural” interest rate would express the exchange rate of present for future goods in a barter economy. If in practice the banks actually charged an interest rate below this natural rate, Wicksell argued that commodity prices would rise, whereas if the banks in practice charged an interest rate above the natural one, then commodity prices would fall. But that’s where Wicksell — often associated with the free-market Austrian school of economics — would cease to recognize his own ideas in current central bank thinking. Wicksell’s natural rate was a freely discovered market price in an economy, which reflected the implicit (real) rate of return on capital investments. For Wicksell, the natural interest rate was not a policy lever to be manipulated, in order to hit some employment or output goal. Yellen and the other Fed economists writing on this topic have conveniently (and probably unwittingly) co-opted Wicksell into their own Keynesian (and exceedingly un-Austrian) framework.
Can the Neutral Rate Be Used to Tweak the Economy?
That’s the theoretical explanation of the neutral or natural rate. From a more practical standpoint, one must ask: How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short-term interest rates (and there hasn’t been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.
(To give a specific example: One of the key alleged pieces of evidence that the neutral rate has fallen in recent years is the sluggish growth of productivity. But suppose the ZIRP of the Fed itself has been choking off real savings and distorting credit allocation among deserving borrowers, and hence has crippled sustainable growth in output? In this case, the Fed models would conclude, “Nope, our policy rate hasn’t been too low, look at the weak productivity growth,” confusing cause and effect.)
In fact, the circular logic is such that economists are far from an agreement on the current calculation, and their admitted model estimation errors are enormous. Contrary to Yellen’s recent monetary policy ruminations, reputable estimates using two different approaches have concluded that the Fed has set policy rates below the neutral rate since 2009.
Things get worse. It’s not merely that we can’t know in real-time what the neutral rate is; we can’t even know after the fact. Suppose the Fed gradually hikes rates, and then the economy crashes. Dovish Keynesians would no doubt say, “We told you not to tighten! The neutral rate was obviously lower than the Fed realized, and they just raised the policy rate above it.” But this isn’t necessarily so. It could be that the policy rate had been below the neutral rate for years, fostering a giant asset bubble which eventually had to collapse. Both theories are consistent with the observed outcome of modest rate hikes leading to a crash.
The great Austrian economist Friedrich Hayek stressed the role of market prices in communicating information to firms and households, and the impossibility that central planners can ever effectively calculate those prices. If the Fed’s economists think they are able to estimate what the neutral interest rate is, then we can dispense with prices altogether. The Fed’s economists can estimate the “neutral wage rates” for various types of labor, the “neutral commodity prices” for various inputs, and so forth, and issue comprehensive plans for the economy, all calculated in kind.
Of course, this is absurd. The point is, in a capitalist economy, the interest rates themselves — as determined in a competitive discovery process in the bond and credit markets — are central to the coordination of the economy. To assume experts at the Fed could determine the proper, optimal interest rate, without that discovery process, is to assume away the real-world information problems that we all can agree market prices solve. Indeed, perhaps this is why our economic problems persist?
Mark Spitznagel is Founder and Chief Investment Officer of Universa Investments. Spitznagel is the author of The Dao of Capital: Austrian Investing in a Distorted World and was the Senior Economic Advisor to Rand Paul.
By Mark Spitznagel
Originally posted om Mises