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The Fed Thinks It Can Use the “Natural” Interest Rate to Fine-Tune the Economy / Frank Shostak / Oct 18, 2016

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.

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.


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