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Best of 2005: There Is No Neutral


I know a lot about art, but I don't know what I like.


Editor's Note: This article was published on 6/15/2005

"We'll know it when we see it." - Federal Reserve Chairman Alan Greenspan on the Fed funds "neutral rate" in testimony last week before Congress.

Much ink has been spilled and considerable navel gazing given to the idea of a neutral Fed Funds rate - a Fed Funds target that neither stimulates too much growth (and inflation) nor causes any real economic contraction (and deflation). The neutral Fed funds rate then is merely the same rate as what economists call the natural rate. When the natural rate and the Fed funds rate are at parity - neutral - policy is considered neither accommodative nor tight. Folks on the sell-side are busying themselves of late trying to figure out when the Fed's current rate hiking cycle will end: when will they reach a neutral interest rate and stop raising the Fed Funds rate?

Practitioners of the Fed's brand of economics debate amongst themselves what the neutral rate actually is: 3%?, 3.5%? 4%? At what Fed Funds rate is the Fed neither stimulating too much nor contracting too much? There are entire academic careers made on exploring this concept - on getting a close estimation of what the neutral rate is.

But here's the thing: actually determining the neutral rate is impossible. And worse, even if you could measure it, manipulating monetary policy toward its achievement actually makes matters worse. Thus it is both impossible to determine and, even if determined, impossible to achieve. I listened to a speech that Frank Shostak made a few months ago that spelled all of this out; now that the neutral rate is causing so much talk on the Street, I thought I would relay his central points.

It is a complex theoretical point Frank makes about why the natural interest rate cannot be actually determined; it involves the concept of time preferences. Interest rates, at their most basic, are the cost of money. A dollar today is worth something different than a dollar in the future. And that difference is based on two things: the intersection of individual time preferences of the buyer and seller of capital and the amount of money stock in the economy. We won't go into the detail because of the complexity and length of the argument, but suffice it to say that getting to the real interest rate (financial market interest rates minus the CPI) is impossible because the real factors (time preferences) and monetary factors (how much money is in the economy) that go into the determination of that rate cannot be separated. Thus, taking the market interest rate less the CPI to determine the real rate is entirely mistaken.

But we digress, since our point is actually driven home more by the fact that even if the Federal Reserve could know the natural interest rate, it would still be impossible to keep Fed policy at it. Why?

Let us assume that some alien from a distant world has brought an infinitely powerful computer that can measure the natural interest rate. And somehow Alan Greenspan has convinced this alien to let him and him alone know the natural interest rate economy-wide. Knowing the natural rate, the Fed then either pumps money into the economy or takes it out as the market's rate of interest changes from this Alien-derived neutral rate.

Of course, the Fed can't simply push a button and evenly add or subtract money to or from the economy. They actually have to do something: they have to pump money into the economy or take it out. And of course, in taking such action - in, say, pushing money into the economy, there are always first receivers of that money and last receivers.

If you are lucky enough to be a first receiver - a commercial bank, Goldman Sachs, Morgan Stanley, heavy borrowers like the construction industry, etc. - you get the money before anyone else. Feeling flush, you take the money and bid up prices in the economy. Other folks further down the receiver list however, get robbed: having seen prices rise economy-wide without their incomes rising in similar fashion, their balance sheets suffer immediately. They aren't making more money but prices have risen; this is why I constantly refer to monetary inflation as robbery. The first receivers of the Fed's money rob the last receivers. Debtors steal from creditors via inflationary credit creation.

Additionally, and this is an important point, the first receivers of the Fed's money immediately have their time preferences lowered. Being richer, they have less pressing need for immediate and necessary goods like food, shelter and clothing; remember, all things being equal, the rich have decreased time preferences versus the poor.

The activities of the Fed - their increase of the money stock in an attempt to reach a neutral rate - creates wealth transfer and time preference adjustments within the economy. Thus, the Fed can NEVER reach a neutral interest rate because the very actions they take to reach it adjust the natural interest rate (the time preferences and money stock in existence) in the economy, creating a constantly moving target.

So the next time you see the Fed's rent-seeking courtiers writing about the neutral rate, know that they are performing an exercise in futility, both in theory and in practice.

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