Central banks pursue a policy of money neutrality. Except when they are seeking a monetary policy to steer the economy. Money neutrality means money has no impact on supply and demand in the real sector. That is, money is just a veil or a cloak. Money’s influence and function are to serve as a medium of exchange to calculate and facilitate natural market prices and forces.
The way central banks pursue their stated goal of money neutrality is to harmonize the Fed Fund’s rate with the Natural rate of interest. For simplicity, the Natural Rate is the rate of interest, which brings savings and investment in equilibrium ex-ante (it is always in balance ex-post).
However, it is not that simple. When referring to a large aggregate macroeconomy, it is not simply setting the market rate equal to the natural interest rate. Here is why.
Money cannot be Neutral
The following summarizes arguments for why money can not be neutral. To date, no central banker or academic can refute this in its totality. The reason we have a central bank is political rather than having a positive effect on the macro economy.
1. How do you define the natural Rate of interest
Definitions of the natural rate vary, and how you define it will change your model. For example, in natura marginal productivity on real mobile capital, price stability, I=S ex-ante, and modern interpretations such as Woodford’s past, present, and future flexible prices in contrast to the world of rigidities, Austrian time preference theory of interest. If you can not define it, how can you target it?
Three posts on the natural rate of interest:
- Natural rate of interest in a barter economy
- Natural rate of interest I=S
- Natural rate of interest based on price stability
2. Empirical estimates are problematic
There exist multiple models and estimates, Holston-Laubach-Williams, and other competing models. Each one has a claim to a number, the rate at a point in time. How can they all be right? If you steer a ship and are off a few degrees, you will end up somewhere else, depending on your model’s output.
However, more critically, a neutral rate of interest is paradoxically impossible because money’s influence is ubiquitous., on par with traveling faster than the speed of light.
Money is about fundamental markets and real market prices than empirics. Money and real factors are intertwined, so you can not have money neutrality or estimate this empirically. The natural rate is in a very real sense and fairy tale. Therefore, estimates are not meaningful.
Econometrically it is challenging to estimate the natural rate of interest. It is beyond the scope of this post. However, Central banks believe that with the right formulas and complicated equations, R-Star is a reasonably accurate measure of the natural rate of interest. I am skeptical about the reasons laid out here: R-Star.
Therefore, they target something that does not exist, except at universities on backboards and books that win awards. However, the equilibrium rate of interest is not something in the world of real markets.
3. Multiple rates of interest
However, even if Central banks could estimate the natural interest rate, there is the problem of the existence of multiple natural rates of interest. Again that is not within the scope of this discussion. (Pierro Straffa, 1932). Here is a further discussion on:
4. Interventions create a feedback loop
Each intervention creates an imbalance in a dynamic economy. Money/purchasing power enters the macro-economy in a specific path, which distorts the market and creates feedback.
Frequent interventions create a more complicated situation with estimating a neutral interest rate. Even if they could pinpoint a rate that brings neutrality, they still have to maintain it, and it is a moving target.
Interest is not neutral buoyancy like a bubble in a quiet pool of water but rather in a dynamic economy that has forces that go up or down simultaneously and instantly, and simply trying to move the water influences the bubble’s path. This is not neutrality.
Money is not injected into everyone’s equality
Money is not injected with equality when it is pumped through the system. Instead, there are first and last receivers.
Therefore, the point that I want to focus on is that money cannot be neutral because when the central bank decides it needs to expand or contract money or purchasing power in the economy, it does not do this by dropping money on people’s doorsteps by helicopters, or in modern speak drones.
Instead, monetary expansion occurs via the banking system. The United States central bank pumps money by lowering the Fed Funds rate (hypothetically in relation to the natural interest rate).
The Fed Funds interest rate is when banks lend reserve balances to each other overnight. This seems like a convoluted way to control the supply of purchasing power. However, it effectively increases or decreases purchasing power in circulation.
The issue here is the opportunity cost of holding money is different for those who are rich and those who are poor. The rich benefit first, and those closest to the money expansion process.
Time preference theory of interest
The time preference theory of interest states that the opportunity cost of saving money is lower for the wealthy. This is because they can make their monthly payments easier than those living on a minimal income. Save money for a poorer person is a much more difficult task.
Therefore, first receivers have more money, and their time preference will be lower.
The last receivers or no receivers become poorer. The opportunity cost for them is higher.
This is a transfer of wealth, a wealth redistribution. This is not a neutral policy.
Therefore, if you inject money, there will be winners and losers. This, again, is not a neutral rate policy.
If rates go up, the first recipients will lose money, and there will be a business cycle.
Any policy is not neutral as it involves a redistribution of wealth.
Therefore, you can only have a neutral money policy if you have free markets.
The historical context of money neutrality
The conversation in modern thought originates with David Hume but became predominant after Knut Wicksell’s work Interest and Price (1898), and Mises’s Money and Credit (1912) development of his theories. Hayek and Keynes discussed and further popularized the economic concept. Robert Lucas also had a discussion but within the context of the Phillips curve. Michael Woodford does not discuss it in his 800-page book on Interest and Prices (2003), but rather he assumes it with his flexible price equilibrium. The Federal Reserve combines this with their FRB/US econometric model and the Taylor rule.
Only the Austrian economists of today directly and repeatedly challenge this concept, such as Murry Rothbard, Frank Shostak, Robert Murphy, William Butos, Steven Horowitz, or Lawrence White.
Free banking is the only money neutrality
That is free banking, where supply and demand for purchasing power are determined by the market rather than by a central authority. Here is a discussion on:
Can money be neutral? Not with the existence of the Federal Reserve. Central banks exacerbate the trade cycle by ensuring the money is not neutral in the short or long run. In contrast, a free market combined with free banking which allows for the organic nature of money to evolve and operate, can be neutral. A classic gold standard is a close proxy also, but free banking is almost synonymous with neutral money. With this, the economy would have a high growth path, lessen the Gini coefficient and have a money macro equilibrium path.