The Fed’s Fantasy on Neutral Interest Rates

In her testimony to the Congress Economic Committee on November 29, 2017, the Fed Chair Janet Yellen said that the neutral rate appears to be quite low by historical standards. From this, she concluded that the federal funds rate would not have to increase much to reach a neutral stance.
The neutral rate currently appears to be quite low by historical standards, implying that the federal funds rate would not have to rise much further to get to a neutral policy stance. If the neutral level rises somewhat over time, as most FOMC participants expect, additional gradual rate hikes would likely be appropriate over the next few years to sustain the economic expansion.
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. Most 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.
The neutral rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is Fed policy makers successfully targeting the federal funds rate towards the neutral interest rate.
This framework of thinking, which has its origins in the 18th century writings of British economist Henry Thornton1, was articulated in late 19th century by the Swedish economist Knut Wicksell.

This post was published at Ludwig von Mises Institute on December 11, 2017.