It is widely accepted that by means of suitable monetary policies the US central bank can navigate the economy towards a growth path of economic stability and prosperity. The key ingredient in achieving this is price stability. Most experts are of the view that what prevents the attainment of price stability are the fluctuations of the federal funds rate around the neutral interest rate.
The neutral interest rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required is for Fed policy makers to successfully target the federal funds rate towards the neutral interest rate.
This framework of thinking, which has its origins in the 18th century writings of British economist Henry Thornton, was articulated in late 19th century by the Swedish economist Knut Wicksell.
The Neutral Interest Rate Framework
According to Wicksell, there is a certain interest rate on loans, which is neutral in respect to commodity prices, and tend neither to raise nor to lower them.
According to this view, the main source of economic instability is the variability in the gap between the money market interest rate and the neutral interest rate.
Note that in this framework of thinking the neutral interest rate is established at the intersection of the supply and the demand curves.
If the market interest rate falls below the neutral interest rate, investment will exceed saving implying that aggregate demand will be greater than aggregate supply. Assuming that the excess demand is financed by the 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 rises above the neutral interest 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 interest rate is in line with the neutral interest 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 it is deviations in the money market interest rate from the neutral interest rate, which sets in motion changes in the money supply, which in turn disturbs the general price level. Consequently, it is the role of the central authority to bring the money market interest rates in line with the level of the neutral interest rate.
According to this view, to establish whether monetary policy is tight or loose, it is not enough to only focus on the level of money market interest rates; rather one also needs to compare money market interest rates with the neutral interest rate. If the market interest rate is above the neutral interest rate then the policy stance is tight. Conversely, if the market interest rate is below the neutral interest rate then the policy stance is loose.
Can we know what the neutral interest rate is?
The main problem here is that the neutral interest rate cannot be observed. How can one tell whether the market interest rate is above or below the neutral interest rate? The law of supply and demand as presented by mainstream economics does not originate from the facts of reality but rather from the imaginary construction of economists. None of the figures that underpin the supply and demand curves originates from the real world; they are purely imaginary.
According to Mises,
“It is important to realize that we do not have any knowledge or experience concerning the shape of such curves.”
Yet, economists heatedly debate the various properties of these unseen curves and their implications regarding government and central bank policies.
Given that such curves do not exist and are, just useful for illustration purposes this implies that it is not possible to establish from non-existent curves the neutral interest rate.
Now, if the neutral interest rate cannot be observed how one can 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 should be lowered.
Banks should adjust the money market interest rate in the same direction as movements in the price level. Note that this procedure is followed today by all central banks.
An increase in the price indexes above a figure believed to be associated with price stability causes Fed policy makers to raise the Federal Funds interest rate target. Conversely, when price indexes are growing at a pace considered as too low the Fed lowers the target.
According to the Wicksellian framework, in order to maintain price and economic stability, once a gap between the money market interest rate and the neutral interest rate is closed the central bank must at all times ensure that the gap does not emerge. In the Wicksellian framework, a monetary policy that maintains the equality between the two rates becomes a factor of stability.
Most experts hold that once the Fed has managed to bring the federal funds interest rate target to the neutral interest rate level then this must mean that the economy has reached a state of equilibrium.
Despite the fact that the neutral interest rate cannot be observed economists are of the view that it could be estimated by various indirect means. For instance, one method to establish the neutral rate has been suggested by averaging the value of the real fed funds rate (fed funds rate minus price inflation) over a long period of time.
Some other economists hold that the neutral rate fluctuates over time and reject the notion that the neutral rate could be approximated by an average figure. In order to extract the unobservable moving neutral interest rate economists now employ sophisticated mathematical methods such as the Kalman filter. However, does all of this make much sense? 
Why the Fed is unlikely to reach the neutral interest rate target?
The whole idea of the neutral interest rate is unrealistic. What the Fed is trying to establish is a level of interest rate that corresponds to the conditions of the free market. Note that in order to establish the neutral interest rate, which corresponds to the free market interest rate, the Fed continuously tampers with interest rates and money supply.
Obviously, this is in contradiction to the free market. Observe that a free market interest rate implies that it originated in an unhampered market. Also, note that the central bank tampering to establish the neutral interest rate is a key factor behind the boom-bust cycles.
In a free market in the absence of central bank monetary policies, the interest rates that emerge would be truly neutral. In a free market, no one would be required to establish whether the interest rate is above or below some kind of imaginary equilibrium.
Furthermore, equilibrium in the context of a conscious and purposeful behavior has nothing to do with the imaginary equilibrium as depicted by popular economics.
Equilibrium is established when individuals’ ends are met. When a supplier is successful in selling his supply at a price that yields profit he is said to have reached equilibrium. Similarly, consumers who bought this supply have done so in order to meet their goals.
In a free market, in the absence of money creation, there is no need for a policy to restrain increases in the price level.
Given the impossible goal that the Fed tries to achieve, we do not expect Fed policy makers to become wise and all-knowing with regard to the correct interest rate.
Summary and conclusion
The whole idea of the neutral interest rate is unrealistic. What the Fed is trying to establish is a level of interest rate that corresponds to the conditions of the free market. Obviously, this is in contradiction to the free market since in a free market there is no central bank. Also, note that central bank tampering to identify the neutral interest rate is a key factor behind the boom-bust cycles. Given the impossible goal that the Fed tries 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.
 Robert L. Hetzel, Henry Thornton: seminal monetary theorist and father of modern central bank. Economic Review, July/August 1987, Federal Reserve Bank of Richmond. Also, see Murray N. Rothbard, Classical Economics, An Austrian Perspective on the History of Economic Thought volume 2, Edward Elgar, p 177.
 Ludwig von Mises, Human Action chapter 16(2), Valuation and Appraisement, p 333.
 Knut Wicksell, “Interest and Prices” A study of the causes regulating the value of money. Reprints of economic classics, Augustus M. Kelley, Bookseller, New York 1965 p189.
 Thomas Laubach and John C Williams, “Measuring the Natural Rate of Interest”. Board of Governors of the Federal Reserve System, November 2001.
 John C. Williams, “The Natural Rate of Interest”, FRBSF Economic Letter October 31,2003.