Neutral or Natural real-interest-rate...

Janet Yellen, at the Fed, in Jackson Hole on Friday expressed her views on the US economy that the sustained improvement in the labor market and growth rate warrants a slow hike in the interest-rate if the incoming data is consistent with the targets set by the bank. The Fed has constantly said that Core-CPE (Consumer-Price-Expenditure) at 1.5% is near the inflation target which is in line with the unemployment rate close to 4.9 % although the growth rate is tepid. However, it is yet unclear that the bank has shifted its official inflation index the CPE  to the Core-CPE which might show the increase in the price-level due to full-employment and wage-hike since inflation from other sources like transport or oil and food show no price-pressures and loss in the domestic value or purchasing power of the dollar. Currency debasing is debated widely in the Political-circles. The Fed’s Fund-rate path demonstrates that it would be near 2-2.5% by 2018 and if we assume the same inflation target we arrive at a real interest rate of 0.25% which means that the real-interest-rate would increase and not fall compared to the present condition when nominal Fed’s fund rate is 0.25-0.5% and inflation is 1.5%, therefore, the real-rate would be 0.5% - 1.5% equals -1% lower than the real rate in 2018. Hence, 3 years down the line we could expect real rates to be higher than today at which the investment-spending would decrease and not escalate and inflation would go down because real rates would be higher than the natural-rate today when spending is low. The current scene explains lower natural real rates when inflation is low and stable little above zero at 1% which might need slight tightening to bring complete price-stability by increasing real-rates and nominal interest rate. Nonetheless, lowering demand to lower the price-level is different from increasing supply and lower the price-level because the former lowers employment and demand, whereas the supply increases employment and vice-versa and lower the price-level. Therefore, the Fed is expected to find or achieve the natural real interest-rate by keeping money-supply loose, and increase supply and lower the price-level than by keeping demand and the price-level low by increasing the real-rates and unemployment.