Blog: Fed Policy-Is the "neutral rate" a myth?

The Fed and other central banks have now stated that they are raising rates to remove “accommodation.” Basically, they want to stop stimulating the economy and go to the much sought after neutral rate, which balances growth/employment and inflation. But what is this neutral rate? How will they know when they get there?

The neutral rate, by central bankers’ own admission, is unknowable even after the fact, though there are a number of formulas for estimating it. The central banks use many of these formulas to set policy. But the inputs to these formulas have to be estimated themselves. They include the expected rate of inflation, the output gap (the difference between actual economic growth and its potential), sensitivities to these factors, and the impact of fiscal policy, among other things. Of course, these numbers change over various horizons. So we can already see the problems with estimating the neutral rate. Estimates used to estimate something unknowable.

But a more serious issue is that the neutral rate itself is conceptually based upon equilibrium economics. It is the point where growth and inflation are balanced and stable. In my books, Chaos and Order in the Capital Markets (Wiley 1991, 1996) and Fractal Market Analysis (Wiley 1994), I discussed how markets and economies are dynamical systems and can never be at the Keynesian ideal of equilibrium. A dynamical system can be “far from equilibrium,” or unbalanced, but also stable because it fluctuates between bounds. In chaos theory, these systems are called “strange attractors.” If the economy is a dynamical system, then a neutral rate of interest that puts growth and inflation at balanced equilibrium is a myth. The neutral rate and the economy will continue to fluctuate anyway. The best the Fed can hope for is that it will fluctuate within bounds that aren’t negative.

This is one reason why “soft landings” are so rare. It is also why we should be careful. Maybe the Fed and other central banks will be lucky this time by achieving the neutral rate of interest just as inflation falls back, so that everything will be in balance. We can certainly hope so, but hope isn’t a strategy. Best to be prepared by monitoring carefully or hedging against either a recession or runaway inflation in case the landing isn’t so smooth after all.

Reprinted from the First Quadrant "Brim Shots" blog.