The idea of a neutral interest rate emanates from the writings of the Swedish economist Knut Wicksell. According to Wicksell,
There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tend neither to raise nor to lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of real capital goods.
In other words, the neutral rate of interest is defined as the rate at which the demand for physical loan capital coincides with the supply of savings expressed in physical magnitudes. (Note that once the neutral rate is reached, the state of equilibrium is attained — implying that the economy is now well balanced and the price level is stable).
The main source of economic instability, it is held, is the variance between the money market interest rate and the neutral rate. If the market rate falls below the neutral rate, investment will exceed saving, implying that aggregate demand will be greater than aggregate supply. Assuming that excess demand is financed by an expansion in bank loans, this leads to the creation of new money, which in turn pushes the general level of prices up.
Conversely, if the market interest rate increases above the neutral rate, savings will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall. Hence, whenever the market rate is in line with the neutral rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level.
Again, this theory posits that deviations in the money market interest rate from the neutral rate is what sets in motion changes in the money supply which in turn disturb the general price level. Consequently, it is the role of the central authority to bring money market interest rates in line with the level of the neutral rate of interest.
According to this view, in order to establish whether monetary policy is tight or loose it is not enough to pay attention to the level of money market interest rates; rather one needs to contrast money market interest rates with the neutral rate. If the market interest rate is above the neutral rate then the policy stance is tight. Conversely, if the market rate is below the neutral rate then the policy stance is loose.
However, how is one to implement this framework? The main problem here is that the neutral interest rate can’t be observed. How can one tell whether the market interest rate is above or below the neutral rate?
Wicksell suggested that policy makers pay close attention to changes in the price level. A rising price level would call for an upward adjustment in the money market interest rate, while a falling price level would signal that the money market interest rate must be lowered.
According to the Wicksellian framework, in order to maintain price stability and economic stability, once the gap between the money market interest rate and the neutral rate is closed the central bank must at all times ensure that a gap does not re-emerge. In the Wicksellian framework a monetary policy that maintains the equality between the two rates becomes a factor of stability. But is this possible? After all, maintaining this equality means that the central bank would have to manipulate the supply of money, which in turn will only make things unstable. (In the present monetary system the Fed is actually directly engaged in the manipulation of the federal funds rate rather than money supply).
What the Fed is trying to achieve belongs to the world of a true free market economy. In a free market economy without a central bank, there would be no such thing as monetary policy. In the absence of central bank monetary policies the interest rates that emerge would be truly neutral.
Also, in a free market no one would be required to establish whether the interest rate is above or below some kind of imaginary equilibrium. In a free market, with the absence of money creation, there is no need for a policy to restrain increases in the price level.
The whole idea of the neutral interest rate is unrealistic insofar as we have a Fed that continuously tampers with interest rates and the money supply. Given the impossible goal that the Fed is trying to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct level of the interest rate.
For a broader exposition of the ideas in this article, see this Mises.org article, on which it is based.