The Myth of Neutral Interest Rate Policy

0:00We hear all the time about the issue of the so-called neutral interest rates and the central bank is aiming at the so-called neutral interest rate. And I was pondering all the time what it's all about. Now, the conventional wisdom suggests that if the central bank will bring the so-called federal funds rate towards this particular rate, we'll have a heaven on earth. We'll have proper stability, everything will be fine, and there won't be any disruptions. So in other words, according to the mainstream thinking, the so-called neutral interest rate represents an environment where prices do not move at all, stable stability, so to speak. And according to mainstream thinking, price stability is the key for having a proper, balanced type of economy.

0:46So if one looks a little bit into this idea, it's not actually modern at all, and in fact, it's got a long history. And you would be surprised the history begins in 18th century by writings of then economist Henry Thornton who actually was the first so-called central banking type of economist and the idea of the neutral interest rates was further articulated by famous Swedish economist Knut Wichsel and it won't be exaggeration on my behalf to suggest that writings of Knut Wichsel are the foundation Congratulations today for the modus operandi of all the central banks worldwide today. Now, so if I'm correct in what I'm suggesting, I believe it will be a good idea to have a look what actually Mr. Wixel are saying.

1:40And you will be surprised to see there's a lot of similarities of what Mr. Greenspan is talking, all the central banks in the world likewise. The key aspect in Wixellian framework is that the fluctuation in prices are driven by the fact that as today modern economists are saying that money market interest rates are fluctuating along the so-called natural interest rate. According to Wixil, if money market trades moves above the natural interest rate, then it sets in motion downward pressure on prices, so-called price deflation, which is bad news, of course. And if money market trades interest rate, which is set in financial markets, is set below the natural interest rate, this sets in motion upward pressure on prices, which is, again, bad news.

2:30And therefore, the ideal setup according to Wixle is to have alignment between the money market trade, or if you want a new language, the federal funds rate, with the natural interest rate. Now, whenever money market interest rate will be in line with natural interest rate, this money market trade also can be labeled as neutral rate, the neutral rate. Now, having said this, we have to ask ourselves, what does it mean the natural interest rate? What actually Wixel meant by that? And in fact, also, Austrian using this term extensively, the natural interest rate. And it's not always been clarified exactly what does it mean. And according to Wixel, natural interest rate is that rate where real supply and real demand for capital are in equilibrium.

3:19In other words, if you remember the so-called first year of economics, we're talking about supply-demand curves, it's a situation where the supply of real capital and demand for real capital intersect, and you have the happy outcome, the equilibrium interest rate, and this equilibrium interest rate in the real world of capital is what Wixel meant by the natural interest rate. Now, how important all that? First of all, if one looks at the whole framework of Wixil and how he established the real interest rates, and he was talking about money market interest rates, but one observes immediately that there is some kind of a dichotomy. Those two are kept in separate compartments.

4:05In other words, the interest rate in the real world is set by real factors, interest rates in financial world set by monetary factors, and they got nothing to do with each other. In other words, changes in money supply got nothing to do with what will determine the real interest rates and likewise. So in other words, what we're seeing here is so-called neutrality of money as far as interest rate determination is concerned. And again, we have to actually ask the question whether it's logical at all, right? But before we discuss all that, we need to ask ourselves what is all to do with the modus operandi and how one really applies a weak selling framework in the modern world.

4:52So as you remember, I suggested that Wixel was arguing that if interest rates in the financial markets are moving along the so-called neutral rate, this creates disruption as far as the fluctuations in the so-called price level. So, when Wixol was asked, and let us say we would like to implement your framework, how actually, practically it can be done, Wixol argued that, well, in reality, we have difficulties to ascertain what natural interest rate is, because we don't observe such a thing, we've never seen such an animal, therefore, we have difficulties really to practically implement such a thing. But nevertheless, he said, don't give up, I have an idea for you. And the idea is that, well, if you are starting to observe that prices are going up, then it means basically that money market interest rates are below the natural rate, and therefore what you have to do as a central banker, push the interest rate up.

5:49And if you observe that prices are falling down, therefore what you have to do, you can push interest rates down, and everything hunky-dory will be alright. If you look at this framework, it's very practical in the sense that most central bankers are applying this particular procedure today to the extent that they perhaps don't really follow absolute levels of price levels but what they're paying attention to are the rate of changes in the various price indices and that's really the modus operandi of this so-called modern banking. Now, Wixel himself has suggested basically that we are not in a position to know what natural interest rates are and where they are at all.

6:35Nevertheless, modern economists today believe that they can discover what natural interest rate is and they're using various sophisticated methods. In fact, some of them starting with very simple ones like long-term average of real interest rate. Now, they will take the federal funds rate divided by consumer price index, or let's say the federal funds rate minus the percent of changes in the price index, and they'll get the so-called real federal funds rate. They'll take an average of the last 24 years or 50 years or whatever, and they'll tell you this is the natural interest rate. Incidentally, this is one of the inputs of the famous Taylor Rule, which is named under the current Undersecretary of Treasury, John Taylor, right? And one of the inputs there is the long average of the real federal funds rate.

7:23Some other more sophisticated guys are saying, well, this is nonsense to talk about one real interest rate or so-called natural interest rate will be just one number. We have to be more realistic because supply-demand curves shift over time and therefore the natural interest rate must move also. But how do you know what it is? Because we never observe, we don't have data for it. How do you find it? So we use various atomic type of methods, very sophisticated methods that even most sophisticated mathematicians don't use it, right? So they apply all this very alarming type of mathematics, one of them like Kalman filter. I don't want to discuss it right now here. And nevertheless, they pretend that they can find the movement or the time series of the natural interest rates.

8:09Well, having said all that, I would now argue that what they're trying to do is mission impossible. In fact, it's exercising futility. So first of all, in contrast to the Wicksallian idea that the interest rate is basically intersection between supply and demand curves of real capital, real saving and real capital, supply of capital and demand for capital, we need to present slightly different definition perhaps, what do we mean by interest rate as such, where it emanates. Now my simple explanation without going immediately to time preference is to start with the issue of cost. I'm arguing, and it's also argued by Mises in various writings, that saving incurs cost basically.

8:58The moment you save, you deny yourself various goods and services that are required to maintain your life and well-being. So if you are very poor and you are deciding to save, you threaten your life. You can dive in immediately, right? So therefore, the cost will be enormous for you. Now if you are wealthier, obviously the opportunity cost of saving will be a little bit lower. And as wealth expands, the opportunity cost of saving is much lower. Now therefore, from here we can deduce one important point. Number one, that if you take a particular dollar, which we'll call present dollar, it's all in type benefit. There's everything beneficial here because you can buy goods and services with the dollar, which will maintain your life and well-being. If, however, you contrast it against safe dollar, which means future dollar, it actually incurs already cost.

9:46And therefore, from here, we can say that as a normal individual, you would assign a premium, a premium to present dollar, Visa the Future Dollar and this premium is really what interest rate is all about or phenomenon of interest is all about or the foundation for interest rate and from here you also can deduce that the moment you assign a premium to a present dollar Visa future dollar that you also assign what Austrian economists call the positive time preference, positive time preference. In other words, we are in the world of time preference story as far as determination of interest rates. Now, let's ask us the following question. Wixel and other modern economies argue that they can tell you what real interest rates are. In fact, Wixel was suggesting that by intersection of real capital or real goods with demand supply, it can tell you what interest rates are.

10:40Well, I tried to do it and I couldn't establish. For instance, if you take one present apple and land it against two future potatoes, I would like to ask you what will be the interest rate here? I haven't got a clue because it's not possible to tell you what the percentage is. Why? Because we have a calculation problem, right? We're measuring two non-homogenous entities. Likewise, if I'm lending you one shirt for three future potatoes, I don't really know what interest rate here at all, right? So therefore, Wixil, neither Wixil, neither any economies in the world, cannot establish real interest rate just by itself. It's just mission impossible. Yet everybody says you can establish real interest rate. So in order to find out what interest rate is and how it's established in the market, you have to introduce, first of all you have to deal with markets, with the world of money, because in the market they have money.

11:31You don't really talk about markets without money. We don't deal with fiction of so-called barter because it doesn't exist doesn't exist and cannot exist by itself this way. So therefore, we have to introduce money economy and how money economy works, very simple. Let's take Mr. Baker here and Baker has produced 10 loaves of bread and what he did, he had a demand for money. He has exchanged 10 loaves of bread for $10, right? Basically, so now he has a demand for dollar and there was given supply of dollars and he exercised the demand by producing something useful, right, 10 loaves of bread. Now, we also know, we have the privilege, as Murray Rothbard writes in his famous book, Man Economy and State, that we have the privilege also to see his time preferences. You know, although we don't really know, but let us pretend we do know.

12:19And we know that Mr. Baker is happy to lend $10, but his minimum requirement, he wants 5% minimum return. That is his minimum requirement. So therefore, he will be a happy lender if you offer him a return back for $10, $10.50. Now, likewise, we found that there is a shoemaker who is happy to borrow $10 and is happy even to pay a 15%. That's really his so-called time preference schedule, if you want, or his particular setup, if you want, which is related to his particular cost structure that he under way operates, opportunity cost. Therefore, we can say that the shoemaker is willing to repay for $10 borrowed today, $11.50. Obviously, there will be some kind of a bargain between these two guys, and let us say they have settled on 10% interest rate, and they're both happy now.

13:09So what happened? Baker lands $10 present dollars, gets in return $11, interest rate of 10%, Shoemaker borrows $10, and repays in the few, one year's time $11, and both very happy, right? And why they're happy? Because that's exactly what they wanted. Nobody really coerced them. That was a very nice trade and everything came to a nice conclusion, right? Now, what do we see here? Now, two things happens here when you observe interest rate determination. Two things. Number one, we have demand supply of money. That's an ingredient part of interest rate determination in the world that we live, because we live through financial market. And we had another real part here, time preference.

13:54However, pay attention that you cannot have interest rate, interest rate by itself just in the world of money in other words demand supply of money apart from time preference will be nonsense right because you have to have something real human beings have to participate here and you cannot also have interest rate determination but pure real factors by itself without money therefore interest rate that we have is that's the only interest we have one interest rate which is driven by two factors monetary factors and real factors and those factors are intertwined, as Murray Rothbard always liked to say, and therefore money cannot be neutral here, there's no neutrality, it's all intermeshed, and no way you can try to separate such entity called real interest rate, or interest rate which is driven by pure time preference by itself, because such a thing never realized, it can never be realized.

14:44If such a thing as real interest rate cannot be realized by itself, obviously it's nonsensical to talk about such an entity. Also, I believe it's nonsensical to talk about natural interest rate because such an entity does not exist. And it's nonsensical to try really to target towards something which never realizes in the real world that we operate, right? It could be some kind of a fiction if you want for classroom or for university, but not in the world we really operate because we have to do real things here. And yet, if somebody believes that this is the case, like the Central Bank of the United States of America or any other central bank, and they're trying to target towards something which does not exist and they don't have any clue where it is, obviously, they can create a lot of problems. When Greenspan was asked, what is the natural interest rate, they've always been asked such a question, he said, when we'll reach it, I'll know, right? I'll tell you, right?

15:36You know, what the hell is talking about? Nobody knows where it is, right, and it cannot be even known, right, because as I said, from my point of view, it cannot really separate such a thing, the moment you can separate such a thing, we don't really deal in the world of human beings, right, we don't deal in the world of markets, we do some kind of a mumbo jumbo, but we don't deal really with the world of the way markets really operate. So, having said all that, let us say that by some chance, econometricians, the Federal Reserve, The Federal Reserve board, smart guys with a lot of mathematical knowledge, came to Mr. Greenspan and told him, listen, I'll give you the natural interest rate and you have to aim towards this natural interest rate. So I'm saying even if you give them the natural interest rate and it will bring the federal funds rate towards this natural interest rate, it still has to maintain this target. And how do they maintain the target?

16:29The smart guys of the Fed told Mr. Greenspan that the Federal funds rate are above the natural interest rate. So according to the Excellent Framework, what you have to do, you have to push now money, right, to pump money, to bring the Federal funds rate towards the natural interest rate, which is now below the Federal funds rate, according to the wise guys of the Fed. So what the FED does? FED first of all sets the target and then it has to pump money. It pumps money, right? Otherwise it cannot adhere to this target. But when money is pumped, and as Professor Hoppe said, there are always first receivers and last receivers, right? Money never been injected to everybody. Nobody gets it instantaneously. There is always somebody who benefits first.

17:16And according to this story, first receivers are getting money and they are really wealthy. Because they got more money now, they are happy and their purchasing power has risen, they are really wealthy. Now, recall what I suggested, that whenever your wealth expands, your time preference actually will be lowered because now your opportunity cost of saving has been reduced right now because you are wealthy because you got now more money, right? And what happens? The time preference is lowered. Of those first receivers and interest rates, so-called time preference rate is supporting now the act of the Federal Reserve. and the Federal Reserve. Now, if time preference will not be supporting the act of the central bank, the central bank would not be able to maintain even for five seconds the reduction or lowering of the federal funds rate because, after all, time preference, the behavior of people is the ultimate driver.

18:10So, after a while, however, the money started to filter through, and I will skip here, and it's starting to filter through and prices are starting to go up. Obviously, the last receivers of money, or no receivers at all, there are plenty of them, right? They're suffering because their purchasing power is falling and what happened, they become poorer now. And since they become poorer, obviously, the opportunity cost to save for them, the cost of saving is much higher. Therefore, they're starting to push interest rate up. So what happens? If Central Bank will stop the game, will not push more money, obviously the rates will go up and that's it. But Central Bank, because the bright economists told them, must push federal funds rate down in order to meet the target of the natural rate, will continue to push more money.

19:00And this is the game we'll have now. We'll have a tug-of-war now between the last recipients and first recipients. Observe the following thing. When first recipients get the money first, they're actually enriched. In other words, there is a transfer of wealth from last recipients to first recipients. Because when I said they got wealthy, it doesn't mean there was an increase in wealth. What we have got now, wealth redistribution from some part of the population to another part of the population. Obviously, such an activity, such a type of outcome cannot be called neutral. Recall, Greenspan and all the other guys are saying we're dealing with neutral case. It's like Murray Rothbard was cracking a joke and saying, can you have a neutral tax?

19:47Is it possible? Obviously, he concluded it's mission impossible, right? There's no such thing as neutral tax, yet most economies are talking about neutral tax, right? And likewise, if you pump money, obviously you cannot have a neutral outcome. Now this tug-of-war can go for a long time and what will dictate this particular procedure, not what central bank can push interest rates and keep them at a low level for many years if they want. The only thing which will stop them is what we call the subsistence fund or the pool of funding. If the pool of funding is still there and what I call the kitty is still okay, things can go on for quite a while. However, if the kitty gets towards a level of emptiness, then of course everything will fall apart and the music will stop, right?

20:34So we really don't know what's the situation right now. But all I can suggest is that this particular game stops occasionally. The central bank usually stops it before the kitty gets empty. Or if the economists tell Mr. Greenspan or whoever in the central bank that they have overshoot, In other words, the federal funds right now, all of a sudden, below the natural rate, below the natural rate, and they say, hey, that's not good, we have to bring it back to the natural rate. That's really what Greenspan is doing right now. We have to raise it. We have to raise it to so-called equilibrium. And by doing this, of course, they're setting in process economic bust. Why? Because all the early recipients of money, all the various activities which were funded on the back of printing presses, now they're under pressure.

21:22And they're suffering because they don't get any more the money which allows them to transfer real wealth from the last recipients, they're going under or they're going bankrupt and we have so-called economic bust. And obviously after a while we have a repetition of this entire story. So what I would like to conclude here is the following, right? that the central bank activities, even if you give them the knowledge of the natural interest rates precisely and even if they'll bring it there, right, the federal funds rate, they will have to maintain it. The act of maintenance means intervention. Intervention means redistribution of wealth. It doesn't matter for a woman how it could have various permutations. It also means setting boom, bust, cycle, disruption. It can never be neutral to the real economy.

22:10So the only proposition as far as having meaningful neutral interest rate, if somebody wants to use such expression, is to have free market. What does it mean, proper free market? Proper free market means you cannot have their central bank. There's no central bank, there's free banking as such, there's proper, honest money like gold or whatever market will decide. Obviously under these conditions, right, you can, whatever interest rate will match, that will be the interest rate. In the free market, nobody will start to tell you this is below equilibrium, above equilibrium. The whole notion of equilibrium will be meaningless, right, and nobody will be even preoccupied with such a thing. So therefore, the only idea of true natural interest rates is when you have free market conditions.

22:55Now, I would like to go quickly through the action of the Fed and what does it mean today to our world today, first of all. The first diagram here shows you the federal funds target rate. Various targets were set over time in between 1990 until present, right? And in order to adhere to a particular target, Fed has to conduct various pumping of money or various injections of money. Sometimes they take money, sometimes they push money in. And that's what the fluctuation in the so-called percent of change in credit, or it's called Fed credit or the Federal Reserve balance sheet, displays here. Obviously, those generations of fluctuations are not smooth at all, right? And given the fact that the monetary pumping is so volatile, it has an immediate effect on the money supply in the system.

23:44Here we present the money FMS, which relies on the Austrian money supply definition. FMS stands for the Falset Money Supply Definition, which again relies on the Austrian money supply definition. And you can see that the Austrian money supply definition in this case, The money supply moves in tandem, that's the dotted line, with the monetary pumping of the Fed, the Fed balance sheet. So, and so you can see all these fluctuations, obviously those fluctuations in money set in motion fluctuations in various markets. An average fluctuation, because as I said at the beginning, when money is pumped, there are always first receivers, last receivers, there are first markets and there are last markets. For instance, the time lag between money injection and bond market, there's no time lag at all.

24:30Stock market, four months. Gold market could be up to seven months. Oil market could be up to 12 months. Base metals could be maybe up to two years sometime, right? And it depends on what kind of base metal we're talking, right? So therefore, if you take on average nominal economic activity, one can reach, again, using some kind of econometrics, on average about 21 months lag, that's an average lag between pumping money and nominal economic activity. So based on this information, we can first of all say the following, that the current monetary policy of the Fed already laid foundation for a significant slowdown that perhaps which may start from the second half of this year, right? Also the current monetary policy also suggesting, all other things being equal of course, We may have a so-called boom or recovery by the year end as far as nominal activity is concerned.

25:21Nominal don't, again, just in nominal income. Now, we shouldn't forget that nominal GDP is a nominal income. It's just money. The more government prints, the harder GDP will be. It's got nothing to do with so-called real stuff because as one of the speakers has suggested, we cannot measure such a thing, real output. It cannot add up potatoes and tomatoes. It's not edible, right? So whenever economists tell you that the economy grew in real terms by 4 or 5%, this is all nonsense in real terms because nobody knows such a thing, how can it measure? Now, another interesting thing, that if we take the changes in monetary policy of the Fed, or the Fed's balance sheet percentage changes, and against the movement in a consumer price index, which we also regard as a nonsensical indicator, nevertheless everybody uses, so we have to use it also, and also given the fact that the Fed reacts to this indicator, so what we observe here is that using the past monetary injection, because it operates with a lag of 17 months here,

26:22one should not be surprised if the gross momentum of the consumer price index may start even softening. It's quite possible, right? Bear in mind that Fed responds to the consumer price index, or to be more precise, to personal consumption deflator, excluding food and energy. In other words, it deals with a human being which doesn't eat and doesn't drive cars, right? That's what the Fed does, right? But nevertheless, that's what they are doing. And bear in mind, look at this chart, you can see that the CPI here is driven by past monetary policies. And Fed reacts to the CPI. What does it mean? That Fed responds to its previous old policies, now it's like a dog chasing its own tail. They're moving in circles all the time, right?

27:08and yet they tell you that they are defending against inflation that they themselves create, right? Now, if we were to have a slowdown, there is always a possibility that this may crack. Why? Because the underlying foundations of American economy, as many speakers have suggested here, is not good at all. I don't want to go into structure right now. I'm almost finishing here. All I can suggest is that if you look at the underlying pool of funding, which I don't know exactly how big it is right now, The Theory of Money and Credit

28:05To support various debts is shrinking, so what I'm suggesting here is if the slowdown were to become significant and the bottom line cannot support all that, you can have a situation where bank lending will start falling apart, in other words, bank loans may shrink, money supply may evaporate or fall quite rapidly, and you can have a nasty scenario also. Now I'm not here to forecast gloom and doom. I believe businessmen should not operate under the scenario of gloom and doom. Even if I'm espousing Austrian economics, I think it's a bad business. If you practice business under the conditions of gloom and doom, it's basically siege mentality. You have to live in the cave. You have to abandon and abdicate from this life. So you have to follow, live normally, right?

28:51But bear in mind that risk factors are very high, right? And bear in mind that you have to be more conservative, as Adrian Day has suggested, very rightly. One has to look for quality. It didn't suggest you don't be in stocks. It said you can be in stocks, but search for quality, right? In other words, don't buy nonsense, don't buy speculation. That's really what our message is today. Thank you very much.