Neutral, Natural, or Normal: An interest rate disaster. Be very afraid.

• Author: Connolly, Bernard

The idea of a natural rate of interest has a long history. Evoked by Henry Thornton more than two centuries ago, it was put center stage by Knut Wicksell more than a century ago. The supreme guru of modern central banking, the "neo-Wicksellian" Michael Woodford, defines it as the equilibrium real rate of return in the (fictional) case of fully flexible prices. Equivalently, in Woodford's world, "the natural rate of interest is just the real rate of interest required to keep aggregate demand equal at all times to the natural rate of output." The problem in the real world is that once there has been a departure from monetary equilibrium, it became virtually impossible to identify the natural rate, still less to establish it.

Anticipating Keynes, one of the greatest--and probably the wisest--of twentieth-century economists, Dennis Robertson, put it very succinctly in 1933, a time when there had very obviously been a departure from monetary equilibrium: "Normality, and its symbol the 'natural rate of interest', seem to be like a path which is plain enough to see while you are treading it, but which is exceedingly difficult to rediscover once you have strayed from it." The truth of Robertson's piercingly accurate judgement can be seen in the monetary events of the past twenty-five years, and not least in the Fed's recent struggles. Just what has all this got to do with the current obsession of the market and of Fed figures with identifying the "neutral rate," often referred to as the equilibrium rate, r* (a concept derided by Keynes), and working out how far above "neutral" the Fed funds rate will have to go to bring inflation back under control, and how far it can go without creating a deep recession?

With inflation running in the autumn of 2022 at way above the Fed's 2 percent target, it is not surprising that FOMC members appear to be more or less unanimous in saying that the funds rate will have to go above the "neutral" level even if that will "bring pain," as Fed Chair Jay Powell has warned. Thus, the projections released with the September FOMC meeting statement portrayed the Fed funds rate as peaking at around 4.5 percent in 2023--producing a rise in unemployment and, implicitly, a recession--and then descending over time to a "long run" level of 2 percent.

What, in the Fed's eyes, is the meaning of the "neutral rate"? In 2003, a very influential paper by two Fed economists, Thomas Laubach (who died tragically young), a close...