It is widely accepted that by means of suitable monetary policies the US central bank can navigate the economy towards a growth path of economic stability and prosperity. The key ingredient in achieving this is price stability.
Some experts are of the view that what prevents the attainment of price stability are the fluctuations of the federal funds rate around the neutral rate of interest also known as the “natural rate.”
The neutral rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is that Fed policy makers successfully target the federal funds rate towards the neutral interest rate.
Once the Fed brings the federal funds rate in line with the neutral interest rate, price stability and thus economic stability can be reached, so it is held.
[RELATED: “The Fed and Bernanke Are Wrong About the Natural Interest Rate” by Joseph Salerno]
Recently, some officials at the Fed have adopted a view that the natural rate is currently very low, and that its decline may reflect a loss of economic potential. If this way of thinking is valid then there are immediate implications for the Fed: a low natural rate means the Fed could not move its short-term federal funds rate very high before policy becomes too tight.
On Wednesday Oct 5, 2016 speaking to a central banking seminar in New York, the Fed’s Vice Chairman Stanley Fischer said that he was concerned that changes in global savings and investment patterns may have driven down the natural rate. As a result he said “we could be stuck in a new longer-run equilibrium characterized by sluggish growth.”
This framework of thinking, which has its origins in the 18th-century writings of the British economist Henry Thornton, was articulated in late 19th century by the Swedish economist Knut Wicksell.1
It is safe to suggest that the current framework of central bank operations throughout the world is based to a large degree on Wicksellian writings.
Knut Wicksell’s Framework for Price Stability
The central element in Wicksell’s framework is the natural interest rate, which Wicksell defined as “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.”2
The natural interest rate is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes.3
In his framework Wicksell makes a clear distinction between the interest rate that is determined in financial markets and the interest rate that is set in the real world without money.
Whilst the interest rate in financial markets is determined by demand and supply for money, the natural interest rate is set by real factors. Money has nothing to do with the determination of interest rates in the real world of goods. According to Wicksell,
Now if money is loaned at this same rate of interest, it serves as nothing more than a cloak to cover a procedure which, from the purely formal point of view, could have been carried on equally well without it. The conditions of economic equilibrium are fulfilled in precisely the same manner.
In the Wicksellian framework, money only affects the price level. The effect of money on the price level is however not direct, it operates via the gap between the money market interest rate and the natural rate.