gold investment, silver investment

Precious metals investment terms A to Z

Neutral Interest Rate

The key concept in modern central banking. And its fatal flaw. The neutral rate of interest, often depicted as r-star (r*). In  the mainstream macroeconomic modeling, the neutral interest rate is treated as the real interest rates that is consistent with output equaling potential and stable inflation.

In others words, the neutral rate of interest is thought to be an equilibrium rate used as benchmark by central banks in conducting their monetary policy. They manipulate the market interest rates to keep them in line with the neutral rate of interest, as – they believe – only then there will be full employment and neither upward nor downward pressures on the price level.

There are, however, several problems with this approach. The most obvious is that the neutral rate is not an observable phenomenon, but a theoretical construct. So it must be inferred from the data and interpreted within given models, which might not be correct. And the extrapolation is indeed usually incorrect. This is why the neutral-rate estimates not only vary considerably but are largely useless.

Neutral Interest Rate and Gold
What is the link between neutral interest rate and gold? The relationship is important although indirect. You see, the alleged decline in the neutral interest rates is a pathetic excuse for the Fed’s ultra-dovish monetary policy, including the ultra-low interest rates. It goes without saying that the Great Recession and the following Fed’s unconventional monetary policy – resulting from targeting the unobservable neutral interest rate – were quite positive for gold prices.

The reasoning of central bankers was that the Fed had to lower the federal funds rate and keep it close to zero for years simply because the neutral interest rate declined. Remember that nobody has ever seen the neutral interest rates. Instead, the policymakers simply interpreted certain developments as symptoms of a decline in those rates and the secular stagnation. It was quite convenient approach, wasn’t?

But what is most funny is that even the Fed’s own estimates of the neutral interest rate indicate that the federal funds rate should be higher (as of October 2019), as the Atlanta Fed’s heatmap below shows. It means that the U.S. central bank is clearly creating macroeconomic imbalances, which can lead to another economic crisis, providing a boost for gold prices.

Figure 1: Prescriptions for the federal funds rate given the measures of neutral interest rate and the output gap.

Taylor Rule Fed Funds and Gold Chart

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