Mainstream thinking considers the central bank a key factor in the determination of interest rates. By setting short-term interest rates, the central bank, it is argued, can influence the entire interest rate structure by creating expectations about the future course of its interest rate policy.
In this way of thinking, the long-term rate is an average of current and expected short-term interest rates. If today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 5 percent, then the two-year rate today should be 4.5 percent ((4%+5%)/2=4.5%).
Conversely, if today’s one-year rate is 4 percent and the next year’s one-year rate expected to be 3 percent, then the two-year rate today should be 3.5 percent ((4%+3%)/2=3.5%).
By this popular thinking, the key role of the central bank is to make sure that the so-called economy is placed on a trajectory of stable economic growth and stable inflation. If, for whatever reason, the economy appears to deviate from the specified trajectory, it is the responsibility of central bank policy makers to place the economy back on track. This is accomplished, so it is held, by influencing short-term interest rates such as the federal funds rate in the US.
It is held that because central bank policy makers tend to pursue transparent policies and aim at minimizing surprises, individuals in the economy, by following various economic indicators, can form a prediction about the likely course of monetary policy.
For instance, if the growth rate of economic activity exceeds the growth rate held by central bank officials as corresponding to stable price inflation and stable economic growth, then it is believed that people will expect the central bank to tighten its interest rate stance. Conversely, it is thought that if economic activity is below the growth rate specified by the central bank officials’ growth rate, it is likely to set expectations that the central bank is going to lower the short-term interest rate. (Note that central banks influence the short-term interest rates by influencing monetary liquidity in markets such as the federal funds market in the US.)
Depository institutions such as commercial banks keep a portion of money that was deposited with them in the Federal Reserve vaults. The money that commercial banks keep with the Fed is called reserves. Banks need reserves in order to be able to clear customers’ financial transactions and to meet the reserve requirements set by the Fed.
On any particular day there are some banks that have more reserves than they require (i.e., they have excess reserves). Conversely, there are banks that have far too little reserves (i.e., they have an insufficient level of reserves). The existence of excess and deficient reserves among various depository institutions creates a market for these reserves, which are also referred to as federal funds.
The interest rate charged for the use of federal funds is called the federal funds rate. This rate is predominantly applied to short-term lending, mostly overnight loans.
The main vehicle that the US central bank employs to alter the quantity of money in the economy, and hence monetary liquidity, is the buying and selling assets. For instance, the Fed buys an asset such as a government bond for $1 million from an individual, Joe. The Fed pays for this asset by writing a check against itself. Joe, the receiver of the check, places it in his bank, let us call it Bank A. This means that Joe’s demand deposits rise by $1 million. As a result, the money supply has increased by $1 million.
Bank A then presents the check for $1 million to the Fed. The Fed honors the check by raising Bank A’s deposits at the central bank by $1 million. What we have here is an increase in Bank A’s deposits with the Fed — an increase in Banks A’s reserve balances.
The increase in the amount of reserve balances (i.e., federal funds) means that we have an increase in the quantity of federal funds available, which for a given demand leads to a decline in the federal funds rate. (Note that by buying assets by the US Fed raises the money supply. The selling of assets produces the exact opposite.)
Maintaining a Target Rate
As a rule, once the federal funds rate target is announced, the market tends to bring the interest rate towards the target in anticipation that the Fed will be successful in achieving the goal. The main task that Fed operators are confronted with is how to successfully maintain the target. The main role of the Fed is to offset various disruptions to the flow of reserves in the federal funds market.
It follows, then, that, according to popular thinking, the central bank reacts to the likely course of economic activity and the inflation rate by varying the short-term interest rate by means of monetary liquidity.
One can infer from this way of thinking that interest rates are in fact determined by inflationary expectations, by the likely pace of economic activity, and by monetary liquidity. Again, the central bank, in response to economic activity and price inflation, either injects or draws out monetary liquidity in order to influence the federal funds rate.
Interest rates in this framework are established by the possible interest rate policy of the central bank in response to various economic indicators — individuals have no active role in this framework of interest rate determination. They are simply confined to forming expectations about future interest rate policies based on economic indicators and the view of the central bank policy makers.
People Assign Higher Values to Present Goods versus Future Goods
The idea that interest rates are determined by the central bank does not make much sense. If one accepts that this is the case, then how were interest rates determined before we had central banks?
In fact, it is individuals’ time preferences, rather than the central bank, that are key in the interest rate determination process. Why is this?
An individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means. The cost of lending, or investing, to him is likely to be very high — it might even cost him his life to lend part of his means. Therefore, he is unlikely to lend or invest even if offered a very high interest rate.
Once his wealth starts to expand, the cost of lending or investing starts to diminish. Allocating some of his wealth toward loans or investments is going to undermine our individual’s life and wellbeing to a lesser extent in the present. On this Mises wrote in Human Action,
That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.
According to Carl Menger in his Principles of Economics,
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period. … All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.
From this we can infer, all other things being equal, that anything that leads to an expansion in the real wealth of individuals should give rise to a decline in the interest rate (i.e., the lowering of the premium of present goods versus future goods). Conversely, factors that undermine real wealth expansion will lead to a higher interest rate.
Increases in real wealth tend to lower individuals’ time preferences whereas decreases in real wealth tend to raise time preferences. The link between changes in real wealth and changes in time preferences is not automatic, however. Every individual decides how to allocate his wealth in accordance with his priorities.
Changes in Time Preferences Shown by Supply and Demand for Money
The lowering of time preferences, i.e., the lowering of the premium of present goods versus future goods (due to real wealth expansion), is likely to become manifest in a greater eagerness to invest real wealth.
With the expansion in real wealth, people are likely to increase their demand for various assets — financial and non-financial — and to lower their demand for money. This process raises asset prices and lowers asset yields, all other things being equal.
Observe that while the increase in the pool of real wealth is likely to be associated with a decrease in the interest rate, the opposite is likely to take place with a fall in the pool of real wealth. People are likely to be less eager to increase their assets, thus raising their demand for money relative to the previous situation. All other things being equal, this preference will become manifest in the lowering of the demand for assets, which lowers their prices and raises their yields.
But what will happen to interest rates if the money supply increases?
An increase in the supply of money, all other things being equal, means that those individuals whose money stock has increased are now much wealthier. This will likely set in motion a greater willingness on the part of these individuals to purchase various assets. This leads to a decline in the demand for money by these individuals, which in turn bids up the prices of assets and lowers their yields.
At the same time, an increase in the money supply sets in motion an exchange of nothing for something, which amounts to the diversion of real wealth from wealth generators to non–wealth generators. The consequent weakening in the real-wealth formation process sets in motion a general rise in interest rates.
Conversely, a fall in the money supply and a consequent strengthening in the real-wealth formation process sets in motion a general fall in interest rates. (Note, however, that this decline in the interest rate cannot be sustainable because of the damage to the process of real-wealth generation.) A decline in the growth rate of money supply, all other things being equal, will set in motion a temporary increase in interest rates.
We can thus see that the key for the determination of interest rates is individuals’ time preferences, which are manifested in the interaction of supply and demand for money.
In this way of thinking, the central bank has nothing to do with the underlying interest rate determination. The policies of the central bank only distort interest rates, thereby making it much harder for businesses to ascertain what is really going on. The essence of interest rate determination is individuals’ time preferences.
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