What Is This "Neutral" Interest Rate Touted By The Fed?

Tyler Durden's picture

Submitted by Mark Spitznagel via The Mises Institute,

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.

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?

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Batman11's picture

The FED are idiots, get used to it.

Look at the money supply leading up to 2008:


Everything is running out of control and the increase in the money supply is going exponential and heading off to infinity.

If we understood money, 2008 wouldn’t have been a “black swan”. We can conclude the FED doesn’t understand money.

Money and debt are opposite sides of the same coin.

If there is no debt there is no money.

Money is created by loans and destroyed by repayments of those loans.

Fisher developed a theory of economic crises after 1929 called debt-deflation, which attributed the crises to the bursting of a credit bubble.

Hyman Minsky came up with “financial instability hypothesis” in 1974 and Steve Keen carries on with this work today.

Steve Keen saw the private debt bubble inflating in 2005, it wasn’t a “black swan” to him.

In 2007 Ben Bernanke could see no problems ahea.

When you see overall debt increasing rapidly a credit bubble is forming, you can then nip it in the bud before the damage gets out of hand. This also can be seen in the nation’s money supply (debt = money).

Get ahead of the FED, understand money.


im-a-nut-job's picture

Its not about money it about control,how to control the rest of the world so that no country or group of countries can chalange there fraud.  FIAT CURRENCY = CONTROL.

Batman11's picture

All the Central bankers are idiots, time to worry.

Why is the world drowning in debt?

No one realises the dangers as everyone in the mainstream uses neoclassical economics with its spurious assumptions about money and debt.

Twelve people were officially recognised by Bezemer in 2009 as having seen 2008 coming, announcing it publicly beforehand and having good reasoning behind their predictions

They saw 2008 as a debt problem and they know you can’t solve a debt problem with more debt which has been the mainstream solution since 2008.

When you don’t understand money and debt you do all the wrong things.


More wrong things.

You need to understand money and debt to know why austerity doesn’t work.

The IMF predicted Greek GDP would have recovered by 2015.

By 2015 it was down 27% and still falling.

The IMF and ECB didn’t understand the effect of the contraction of the money supply from austerity.

Richard Koo explains:


The ECB is still doing austerity, they haven’t yet understood money and debt and its effects on the money supply.

We should be worried.

If you enjoy laughing at the experts, the IMF forecast (that the ECB went along with) and the reality are at 54.30 mins.  



Batman11's picture

The Western experts advise Japan and disaster follows.

Richard Koo explains (first 10 mins):


In a globalised world everyone sticks to their dogma and refuses to learn from experience.

Japan – 1989 - real estate bust that it still hasn’t recovered from.

US, Ireland, Spain, Greece, UK, Canada, Australia, Holland, Sweden, Norway, China – I am sure there can be no problems with real estate bubbles.

Japan – 1989, US -2008, Ireland, Spain - calamitous real estate busts.

Canada, Australia, Holland, Sweden, Norway, China – I am sure there can be no problems with real estate bubbles.

“Stocks have reached what looks like a permanently high plateau.” Irving Fisher 1929.

Inflating asset prices doesn’t create real wealth.

The bubble bursts and its gone.

Tulip bulbs in 1600s Holland – exactly the same, it’s always been that way. 

The lunatics have taken over the asylum.

J J Pettigrew's picture

Fake interest rates put the brakes on the Velocity of Money.

IF and WHEN that velocity turns around, the inflation will be stifling...




turnball the banker's picture
turnball the banker (not verified) Jan 5, 2017 4:48 AM

That Yellen is one hot looking joo.While the joo has infected the fed and gov stealing and corruting you are well and truly fucked

Bearwagon's picture

Yeah, "market" ... sure. I call that baloney - there ain't no such thing. Does anyone remember the "Volcker-shock"? Rising rates syphoned capital from all over the world and channeled it into the U.S.A. It was a basis for the success of the following financial industrie, and the "third world" countries had to foot the bill. And guess what? That's the plan all over again: Rising rates shall attract capital to the US economy, only this time it will not be countries like Mexico that will have to pay for it, but (IF things go according to plan) China. This will shirley end well ...

MEFOBILLS's picture

Money and debt are opposite sides of the same coin.

In a debt money system, where banks create their "credit" at the same time as a debt instrument, this statement is true.  Today, bank credit is 97% of the money supply in U.S.  In years past, other kinds of money were in the supply.  For example, U.S. Notes are exogenous to the bank system, and don't require a debt instrument.  In England, paper and coin are exogenous money.  From 38 to 74 the Bank of Canada issued debt free money into Canadian money supply.


If there is no debt there is no money.

Debt free money can be issued, and has been issued many times in history.  Usually during war, or the run up to war, countries dispense with the canard that money must relate to debt instruments.  The true nature of money is law ... not debt instruments.  The best kind of money fluxes in relation to goods and services.

Money is created by loans and destroyed by repayments of those loans.

Bank credit is created by loans and is destroyed when it pays down principle.  During the first accounting cycles of a new loan, repayment is mostly usury.  Usury interest on the loan passes through your double entry ledger upon repayment, and then lands on the banker's ledger.  Banker then is "paid"  more upfront on the loan cycle, and this usury is also seigniorage.  This seigniorage gives more purchasing power up front as gains to banker, rather than back end of loan cycle, when the principle is paid down faster and purchasing power is less.  All banker credit driven economies have a sawtooth, where credit supply expands for awhile, then collapses quickly into depression/recession.

A credit bubble is forming:

Credit bubble occur when new bank credit chases after assets that are not real wealth.  This then pushes prices in non-real asset classes.  For example, during the 20's new bank credit was hypothecated against the stock market.  This then pushed stock prices by the mere creation of credit.  Prices did not reflect reality.

The housing bubble was the same mechanism.  New bank credit aimed at housing sector, pushing house prices.  In many cases, housing just changed hands - which is non value add.  New housing stock cannot come on line in already land locked areas.  

Bank credit is a low form of money, and seldom vectors into productivity modes, hence it is prone to bubbles.  Frederick List (circa Kaiser era in Germany) used government credit to build industry.  In this case, credit as money created real wealth, and was the reason for Germany's success.

Batman11's picture

80% of bank lending in the US and UK goes into real estate as the bankers don't understand their debt products.

Let's take an existing asset and inflate its price, it never creates real wealth.

The bubble bursts and its all gone.


Bearwagon's picture

The point is to make someone else foot the bill when the bubble bursts. Always has been. Aaand it's gone ...

MEFOBILLS's picture

80% of bank lending in the US and UK goes into real estate as the bankers don't understand their debt products.


When something happens over and over, it is a feature of the system, not a fluke.  

Real Estate dotted line connects to your double entry ledger upon hypothecation.  These dotted lines are law.  Your real estate can be grabbed during harvest phase.  Harvest phase occurs during the rapid collapse, or sharp downward edge of sawtooth.  Real assets, such as land/patents/business, are swapped to cancel the debt instrument.

So, Magickal swaps are another design element of private banking.  Swaps are almost always uneven...something like a butcher putting his thumb on the scale.  Swaps are more usury.

All the whining about Fiat and Keynes are due to this sharp drop of credit driven economies.  Keynes merely proposed that government counter spend to offset the depression cycle.

During Keynes lifetime, Germany avoided the great depression by using MEFOBILLS.  Tax roles almost trippled between 33 and 38, with little inflation, and no depression.  This proved Keynes correct.  Keynes only has stop gap solutions for debt money system.  The system itself is the problem, and should be scrapped.


lester1's picture

Janet Yellen is going to try to fuck Trump by raising interest rates as much as she can this year. It's going to backfire because it's going to cause Emerging Markets to crash and a tidal wave of foreign money to pour and United States chasing higher interest rates and yield. Higher debts are sustainable if interest rates stay below 3%. In other countries treasury yields aren't even close to what ours is. If Trump follows through and makes America an attractive place to do business again, more foreign money will pour into the United States like never before. The Federal Reserve will be irrelevant.


Yellen needs to go when her term is up in 2018. She's no friend of president Trump. Trump will use her as a useful idiot for now. I would love to see Ron Paul put on at the Fed head. He would totally clean up the corrupt Institution.

im-a-nut-job's picture

She may want to fuck Trump but i dont think Trump would want to fuck her.

lester1's picture

He would have to put a bag on her ugly liberal head first.

JailBanksters's picture

Neutral ...

Not Positive

Not Negative

I'm thinking somewhere in between the two, Like ZERO

But you can't keep saying Zero for 8 years, people MIGHT start catching on. So Instead it's now called Neutral. So the cost of creating money out of thin air to go buy stuff, is Neutral.

Maybe this Neutral thing will catch on this Two Thousand Neutral and Seventeen.

See it's catching on already.


im-a-nut-job's picture

IT aint neutral if there is inflation.

J J Pettigrew's picture

Historical neutral has been the inflation rate (1.6% as they measure it) plus 1/3 of that rate.

Thus interest rate "equilibrium" should be about 2.3%.....short rate.....

Right Janet?

JailBanksters's picture

It's only Neutral for Bankers, not you.

And because Inflation is NOT measured by Food or Fuels, how do you know what the Inflation is unless these Morons running the enslavement camps tell you what the Inflation Rate is.

ICValue's picture

Banks perform the value creation equation twice by the nature of their business. When a trade is made, both participants walk away with more of what they wanted than what they had. One plus one equals more than 2. Banks perform this trade with depositors and creditors. So the interest rate question starts with how much a bank has to pay in interest a depositor to earn the use of that deposit as a loan. 

An easy solution is limiting government to the protection of rights. These rules about how a trade can be made (within and without banking) create imbalances that do not self adjust; then the only solution by those that can only make rules is to make a new rule thereby expanding the potential for even greater imbalance. So the rule is a tool to create outcomes without respect to the most efficient use of resources determined by the market. I have hope.

overmedicatedundersexed's picture

the special people can print money for 6% interest..(FED)..so much fraud and corruption goes with this special privilege..that only a JU must control it..now back to sleep amerika, don't ask why Hitler saw them as a threat to German economy- WWII was the final victory for the JU...now look around at who owns everything today.

Last of the Middle Class's picture

Evidently the Fed's biggest problem these days is coming up with another ambiguous word for their meeting with which to spray feces in the faces of US citizens.

J J Pettigrew's picture

The Federal Reserve, neither Federal or in possession of its own reserves, is an anethema to FREE MARKETS.

They PEG the rates....estimating equilibrium ..... WHY NOT LET THE MARKETS DO THIS?????

power and money

They changed in 08 with the crisis an opportunity to self expand their powers and redraw their mandates.


TeaClipper's picture

And look no further than Bitcoin if you want to see how well a market can perform unhindered by Governments and bankers

lester1's picture

Eventually the trading desks at central bank offices will be manipulating Bitcoin too. It's coming!

TeaClipper's picture

No doubt, but i wasn't peddling bitcoin, far from it. My point was that when government's and banks leave the market alone, the market thrives. At the moment they are not cannot fuck with that market and look at it. Bitcoin love it or loathe it has been the best performing currency two years in a row

UnKeynes's picture

The arrogance of the neo-Keynesians is truly stupendous.  As if the entirety of their manipulations to date have yielded anything but gross mismanagement of the economy.  So (one more time) just WHO DECIDES WHAT, WHEN AND HOW to "do" a "neutral" interest rate?? 

One guess.

And it ain't Mr. Market.

orangegeek's picture

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.




It's the rate that keeps the market indexes up - Fed could care less about the economy (one big fucking lie).


So why markets up??  So barry can tell the world that his marxism is the future to economic growth - like the child-like lines of argument in the 1970s that the USSR was a "superior" society.


January 20 - all bets are off and markets drop - Trump will be blamed by the lugenpresse and barry will still be flapping his yap.

angry_dad's picture
angry_dad (not verified) Jan 5, 2017 10:41 AM

it's time for the little goof (yellen) to resign

how can anyone besides obama be 100% wrong all the time

angry_dad's picture
angry_dad (not verified) Jan 5, 2017 10:42 AM

the usa would be transformed tomorrow into a paradise if rates were raised to 6% immediately.