The Fed Is Chasing Unicorns
Last November, Fed Chair Jerome Powell said interest rates were “just below the broad range of estimates of the level that would be neutral for the economy.” This was the excuse for the central bank’s monetary policy 180 and set the stage for the “Powell Pause.”
Central bankers are perpetually on a quest to find the elusive neutral interest rate, but in fact, it’s an impossible goal, as economist Frank Shostak explained in an article published on the Mises Wire.
Basically, the Fed is chasing unicorns.
As Sostak defines it, the “neutral interest rate” is one that is consistent with stable prices and a balanced economy. The quest for the Fed is to find this mythical rate. By targeting the federal funds rate toward the neutral interest rate, central bankers believe they can navigate the economy toward a growth path of economic stability and prosperity.
This economic idea has its origins in the 18th-century writings of British economist Henry Thornton and was later articulated by the Swedish economist Knut Wicksell. Sostak explains:
According to Wicksell, there is a certain interest rate on loans, which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. According to this view, the main source of economic instability is the variability in the gap between the money market interest rate and the neutral interest rate.
Note that in this framework of thinking, the neutral interest rate is established at the intersection of the supply and the demand curves.
If the market interest rate falls below the neutral interest rate, investment will exceed saving, 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 interest rate rises above the neutral interest 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 interest rate is in line with 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, this theory posits that it is deviations in the money market interest rate from the neutral interest rate, which sets in motion changes in the money supply, which in turn disturbs the general price level. Consequently, it is the role of the central authority to bring the money market interest rates in line with the level of the neutral interest rate.
According to this view, to establish whether monetary policy is tight or loose, it is not enough to only focus on the level of money market interest rates; rather one also needs to compare money market interest rates with 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.
That all sounds well and good. But here’s the $64,000 question: what exactly is the neutral weight? Nobody knows. In fact, it’s impossible to determine. We can’t observe the neutral rate. We can’t tell if the market rate is above or below neutral. We might as well be hunting for unicorns.
And yet this is a central tenet of central bank monetary policy.
Sostak says the whole idea of a neutral interest rate is “unrealistic.”
What the Fed is trying to establish is a level of interest rate that corresponds to the conditions of the free market. Note that in order to establish the neutral interest rate, which corresponds to the free market interest rate, the Fed continuously tampers with interest rates and money supply.
Obviously, this is in contradiction to the free market. Observe that a free market interest rate implies that it originated in an unhampered market. Also, note that the central bank tampering to establish the neutral interest rate is a key factor behind the boom-bust cycles.
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 kind of imaginary equilibrium.
Furthermore, equilibrium in the context of a 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 equilibrium. Similarly, consumers who bought this supply have done so in order to meet their goals.
In a free market, in the absence of money creation, there is no need for a policy to restrain increases in the price level.
Given the impossible goal that the Fed tries to achieve, we do not expect Fed policymakers to become wise and all-knowing with regard to the correct interest rate.
The Fed is chasing unicorns. And of course, it will never catch one.