The Fed and low interest rate policy

By Dr Frank Shostak

It is a commonly accepted view these days that the central bank is a key factor in the determination of interest rates. On this way of thinking, the Fed determines the entire interest rate structure by influencing the short-term interest rates.

The central bank influences the short-term interest rates by means of the monetary liquidity. Thus, by buying assets the Fed adds to the monetary liquidity thereby lowering rates. Whilst by selling assets, the exact opposite is taking place.

According to the popular thinking, the Fed also influences the long-term rates, which are seen as an average of current and expected short-term interest rates. 

If today’s one year rate is 4% and the next year’s one-year rate is 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 the 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%.  

Given the supposedly almost absolute control over interest rates, it is held that the central bank through the manipulations of short-term interest rates can navigate the economy along the growth path of economic prosperity.  

For instance, when the economy is thought to have fallen to a path below that of stable economic growth it is held that by means of lowering interest rates the central bank can strengthen the aggregate demand. This in turn it is held is going to be supportive in bringing the economy onto a stable economic growth path.  

Conversely, when the economy becomes “overheated” and moves to a growth path above that, which is considered as stable economic growth, then by lifting interest rates the central bank can push the economy back to the path of economic stability.  

Again, on this way of thinking, it seems that the central bank is in charge of interest rates and thus the direction of the economy. However, is it the case? Is it valid to hold that the central bank is the key in the determination of interest rates?

Individuals time preferences and interest rates  

According to the founder of the Austrian School of economics, Carl Menger, the phenomenon of the interest is the outcome of the fact that individuals assign a greater importance to goods and services in the present versus identical goods and services in the future. 

The higher valuation is not the result of some capricious behaviour, but due to the fact that life in the future is not possible without sustaining it first in the present. According to Carl Menger, 

Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economizing men generally endeavor to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.

Hence, various goods and services that are required to sustain individual’s life at present must be of a greater importance to him than the same goods and services in the future. The individual is likely to assign higher value to the same good in the present versus the same good in the future.

As long as the means at an individual’s disposal are just sufficient to accommodate his immediate needs, he is most likely going to assign less importance to future goals. With the expansion of the pool of means, the individual can now allocate some of those means towards the accomplishments of various ends in the future. 

Life sustenance and the zero interest rate   

As a rule, with the expansion in the pool of means, individuals are then able to allocate more means towards the accomplishment of remote goals in order to improve their quality of life over time.   With paltry means, an individual can only consider very short-term goals, such as making a basic tool. The meager size of his means does not permit him to undertake the making of more advanced tools.  With the increase in the means at his disposal, the individual could consider undertaking the making of better tools. 

Note that very few individuals are likely to embark on a business venture, which promises a zero rate of return. The maintenance of the process of life over and above hand to mouth existence requires an expansion in wealth. The wealth expansion implies positive returns. 

Again, whilst prior to the expansion of wealth the need to sustain life and wellbeing in the present made it impossible to undertake various long-term projects, with more wealth this has become possible. 

Does the lowering of the interest rate permit greater capital formation?

Contrary to the popular thinking, a decline in the interest rate is not the driving cause behind the increases in the capital goods investment. What permits the expansion of capital goods is not the lowering of the interest rate but the increase in the pool of savings. 

The pool of savings, which comprises of final consumer goods, sustains various individuals that are employed in the enhancement and the expansion of capital goods i.e. tools and machinery. With the increase in capital goods, it will be possible to increase the production of future consumer goods. 

Individuals’ decision to allocate a greater amount of means towards the production of capital goods is signaled by the lowering in the individuals’ time preferences i.e. assigning a relatively greater importance to the future goods versus the present goods.  

Hence, the interest rate is just an indicator as it were, which reflects individuals’ decisions. (Again, the decline of the interest rate is not the cause of the increase in capital investment. The decline mirrors the individuals’ decision to invest a greater portion of his resources). 

In a free unhampered market, a decline in the interest rate informs businesses that individuals have increased their preference towards future consumer goods versus present consumer goods. Businesses that want to be successful in their venture must abide by consumers’ instructions and organize a suitable infrastructure in order to be able to accommodate the demand for consumer goods in the future. 

Note that through the lowering of their time preferences individuals have signaled that they have increased savings in order to support the expansion and the enhancement of the production structure.

Central bank easy policies set boom-bust cycles

Observe that in a free unhampered market fluctuations in the interest rate are going to be in line with the changes in consumers’ time preferences. Thus, a decline in the interest rate is going to be in response to the lowering of individuals’ time preferences. Consequently, when businesses observe a decline in the market interest rate they are responding to this by lifting their investment in capital goods in order to be able to accommodate in the future the likely increase in consumer goods demand. (Note again that in a free-market economy a decline in the interest rate indicates that on a relative basis individuals have lifted their preference towards future consumer goods and services versus present consumer goods and services).

As a rule, a major factor for the discrepancy between the market interest rate and the interest rate that reflects individual’s time preferences is the actions of the central bank. For instance, an aggressive loose monetary policy by the central bank leads to the lowering of the observed interest rate. Businesses respond to this lowering by increasing the production of capital goods i.e. tools and machinery in order to be able to accommodate the demand for consumer goods in the future. 

Note that the lowering of the interest rate here is not in response to the decline in consumers time preferences. Consequently, businesses by responding to this lowering of the interest rate do not abide any longer by consumers’ instructions. Note that since consumers did not lower their time preferences they did not increase savings to support the increase in the capital goods investment. 

Observe; that every economic activity must be funded i.e. individuals engaged in the activity must be allocated the necessary means to support their lives and well-beings. One of the ways to facilitate the necessary funding is for the businesses to utilize borrowings from banks. On account of the easy monetary policy of the Fed and the emerging sense of prosperity banks are finding it attractive to engage in the expansion of lending. 

The banks expansion of lending sets in motion an increase in the credit out of “thin air” i.e. unbacked by savings lending. This in turn gives rise to the increase in the growth rate of money supply. Increases in the money supply growth rate make it possible for the businesses to divert to themselves wealth from genuine wealth generators. This in turn undermines the wealth generation process. In this sense, these businesses are setting in motion activities that most likely would not be supported by the free unhampered market economy. These activities, which we label them as bubble activities, are a burden on the wealth generators since they cannot stand on “their own feet”.  

As long as wealth generators are producing enough wealth, bubble activities are prospering against the background of increases in the money supply growth rate. Also, note that the expansion in bubble activities weakens the wealth formation. This in turn exerts an upward pressure on the time preference interest rate. (Note that with less wealth at their disposal individuals’ are likely to increase their preference towards present goods versus the future goods).This works towards the widening in the gap between the time preference interest rate and the market interest rate. Once however, the wealth generation process weakens significantly, i.e. when the pool of wealth either stagnates or declines, bubble activities come under pressure. 

The demise of these activities as a result of the decline in the pool of wealth sets in motion a severe economic slump.  Note again that bubble activities survive on the back of the loose monetary policies of the Fed. (The loose monetary policy diverts to bubble activities wealth from genuine wealth generators. Also, note that bubble activities could come under pressure if the Fed were to tighten its stance).

Because of the widening in the gap between the time preference interest rate and the market interest rate, businesses have overproduced capital goods relatively to the production of present consumer goods. At some stage, by incurring losses, businesses are likely to discover that past decisions with regard to the capital goods expansion were erroneous. 

As a result, businesses are likely to attempt to correct the past errors. Observe that whilst an over-production in capital goods results in a boom, the liquidation of the over-production produces a bust. Note that the overproduction is because of the misallocation of resources brought about by businesses not abiding by consumers instructions. The longer the central bank tries to keep the interest rate at very low level the greater the damage it inflicts on the wealth formation process. Consequently, the longer the period of stagnation is going to be. 

Conclusions  

As long as life sustenance remains the ultimate goal of human beings, they are likely to assign a higher valuation to present goods versus the future goods and no central bank interest rate manipulation is likely to change this. Any attempt by central bank policy makers to overrule this fact is going to undermine the process of wealth formation and lower individual’s living standards. 

The central bank can manipulate the interest rate to whatever level it desires. However, it cannot exercise a control over the interest rate as dictated by individual’s time preferences. It is not going to help economic growth if the central bank artificially lowers interest rates whilst individuals did not allocate an adequate amount of savings to support the expansion of capital goods investments. It is not possible to replace saved wealth with more money and the artificial lowering of the interest rate. It is not possible to generate something out of nothing as suggested by many commentators. 

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One reply on “The Fed and low interest rate policy”
  1. says: Chris Rimmer

    “The pool of savings, which comprises of final consumer goods” — Yes! Accumulating non-commodity (debt) money is not saving as far as the whole economy is concerned, because it decreases the issuer’s net worth by as much as it increases the holder’s.

    There is another way to understand the interest rate: consider a basic bank’s change in net worth over time. The only way its net worth increases is when it charges interest. (E.g. when a borrower repays principal with cash, the bank’s cash assets increase, but its loan asset decreases by exactly the same amount.)

    Decreases in net worth come from:
    1. Defaults by borrowers.
    2. Costs of business (employees’ wages, heating & lighting, etc.)
    3. Dividends to shareholders.

    If a bank doesn’t charge an interest rate high enough to cover these 3 items, its capital level falls, and it is guaranteed to become insolvent. If the central bank manipulates the interest rate lower, it increases insolvency somewhere in the economy, for which someone will eventually pay.

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