Aiming for a happy medium

What is America's neutral interest rate? - Economist.com | Economics focus: "THE decision by America's Federal Reserve to raise the federal funds rate by a quarter of a percentage point, to 2.25%, on December 14th should have surprised no one. The Fed has nudged rates up in quarter-point steps at each of its last five meetings, and makes no secret of its intention to carry on doing so for a while yet. Its chairman, Alan Greenspan, said recently that anyone who has not prepared for higher interest rates is "obviously desirous of losing money."

The Fed's favourite gauge of inflation, the rate of increase of the core personal consumption expenditure deflator, was 1.5% in the year to October, implying a real interest rate of only 0.75%. According to another measure, the University of Michigan's estimate of expected inflation over the next year, now 3%, the real fed funds rate is still negative.

So how high might the fed funds rate go? It is commonly agreed both on Wall Street and in Washington that rates are heading back towards a “neutral” level. The notion of a neutral (or “natural”) rate of interest was developed by Knut Wicksell, a Swedish economist writing about a century ago. Wicksell saw this rate as one that was consistent with stable prices and that balanced the supply of and demand for capital.

In its modern incarnation, the neutral rate is the real, short-term interest rate consistent with stable inflation and an economy that is growing just in line with its potential: it keeps the pot cooking, without either boiling over or losing heat. If the real interest rate is below neutral level, monetary policy is loose: if above, policy is contractionary. Several monetary-policy rules of thumb (notably the Taylor rule, named after John Taylor, an economist who is now an official in America's Treasury Department) rely heavily on the idea. The neutral rate is also implicit in the Fed's explanation of its strategy. When it speaks of removing “accommodation” it is, in effect, saying that real rates are below their neutral level.

So much for the theory. What, in practice, is the neutral rate? Unfortunately, the real rate that would keep the economy growing in line with potential and inflation stable cannot be measured directly. It has to be inferred from the actual, nominal rate, the current level of output, estimates of the trend rate of growth and measures of expected inflation. Some economists like to estimate the real federal funds rate over long periods of time and use that as a proxy for the neutral rate. "