Does the central bank determine interest rates?

According to mainstream thinking, the central bank is the key factor in determining interest rates.

By setting short-term interest rates, the central bank, it is argued, through expectations about the future course of its interest rate policy can influence the entire interest rate structure.

Thus according to the popular 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% and next year’s one-year rate expected to be 5%, then the two-year rate today should be 4.5% (4+5)/2=4.5%.

Conversely, if today’s one year rate is 4% and next year’s one-year rate expected to be 3%, then the two-year rate today should be 3.5% (4+3)/2=3.5%.

Note that interest rates in this way of thinking are established by the central bank whilst individuals in all this have almost nothing to do and just form mechanically expectations about the future interest rate policy of the central Bank.

Individuals here are passively responding to the possible interest rate policy of the central bank. However, does it make much sense?

We suggest that the key in interest rates determination is people’s time preferences. What is it all about?

 

People assign higher valuation to present goods versus future goods

As a rule, people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods.

This stems from the fact that a lender or an investor gives up some benefits at present. Hence, the essence of the phenomenon of interest is the cost that a lender or an investor endures.

On this Mises wrote,

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.[1]

Also, according to Mises,

The postponement of an act of consumption means that the individual prefers the satisfaction which later consumption will provide to the satisfaction which immediate consumption could provide.[2]

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 if he were to consider lending 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 towards lending or investment is going to undermine to a lesser extent our individual’s life and wellbeing at present.

From this we can infer, all other things being equal, that anything that leads to the expansion in the real wealth of individuals gives 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 lead to a higher rate of interest.

 

Changes in time preferences mirrored through supply and demand for money.

The lowering of time preferences, i.e. lowering 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 lower their demand for money. In the process, this raises asset prices and lowers their yields, all other things being equal.

Note that the increase in peoples’ demand for various assets as a rule tends to be preceded by the increase in the differential between the growth rates of the supply of money versus the demand for money.

(Note again an increase in the differential as a rule precedes an increase in the demand for assets, which results in the increase in asset prices and the decline in their yields).

Observe that whilst the increase in the pool of real wealth is likely to be associated with a lowering in the interest rate. The converse is likely to take place with a fall in the real wealth.

People are likely to be less eager to increase their demand for various assets thus raising their demand for money relative to the previous situation.

As a rule, this reduces the differential between the growth rates of the supply of money versus the demand for money.

Within all other things, being equal this will manifest in the lowering of the demand for assets thus lowering their prices and raising their yields.

 

What will happen to interest rates because of an increase in money supply?

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.

Hence, this sets in motion a likely greater willingness of these individuals to purchase various assets. This leads to the lowering of the demand for money by these individuals.

An increase in the supply of money coupled with a fall in the demand for money leads to the increase in the differential between the growth rates of the supply of money versus the demand for money. This in turn bids the prices of assets higher and lowers their yields.

However, an increase in 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.

After a time lag, the increase in money supply and a consequent weakening in the real wealth formation, which manifests by a general increase in prices, sets in motion a general rise in interest rates.

Note that it is not the increase in prices as such that lifts interest rates but the increase in time preferences because of the weakening in the real wealth formation.

The increase in prices means that now more money chasing less goods. It is just an indicator as it were.

Conversely, after a time lag a fall in money supply and a subsequent strengthening in real wealth formation, which manifests in a general decline in prices, sets in motion a general fall in interest rates.

Also, note that an increase in the growth rate of money supply, all other things being equal, sets in motion a temporary fall in interest rates. A decline in the growth rate of money supply, all other things being equal, sets 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 manifests through the interaction of supply and demand for money.

 

 

[1] Ludwig von Mises, “Human Action” Contemporary Books, 3rd revised edition p 97.

[2] Ludwig von Mises, Human Action, p 482.