Interest Rates Set By The Market vs. Interest Rates Set By The Fed
The Fed has kept interest rates at near zero since the 08 economic crash. For the last year the Fed has floated the trial balloon that they would raise interest rates this September by a mere quarter of a point. The Fed huffed and puffed and failed to follow through with this increase. To understand if the original lowering of the interest rate and the failure to raise the interest rate is good or bad, a few questions have to be answered.
What is an interest rate? How is an interest rate determined? What is its purpose? What happens if the interest rate is set artificially?
We will attempt to answer these questions with some excerpts from these articles, Central Banks Don’t Dictate Interest Rates, Frank Shostak, and Low Interest Rates Cant Save A House Of Cards, by Richard Ebeling. These articles give great explanations about interest rates, central banks, and the Austrian business cycle theory. Take time to read them.
WHAT IS AN INTEREST RATE
Individuals place a higher value on a good possessed in the present than a good possessed at some point in the future. The interest rate is the difference in time preference made by each individual between possessing a good in the present as opposed to the future. Put differently, the premium we place on present goods compared to future goods, or the discount we place on future goods compared to present goods is the interest rate.
Shostak –“…… 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.”
“……For instance, an individual who has just enough resources to keep himself 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. So under this condition 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 lending or investment is going to undermine, to a lesser extent, our individual’s life and well being at present. From this we can infer that anything that leads to an 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.”
HOW INTEREST RATES ARE DETERMINED
The time preference of all individuals determines the interest rate. As savings by individuals accumulate the interest rate decreases. As savings by individuals diminish the interest rate increases. The amount of savings determines the interest rate, the interest rate doesn’t determine the amount of savings. When the interest rate is falling we are saving more and consuming less, which means resources are being saved for future consumption. When the interest rate is rising we are consuming more and saving less, which means resources are being used for present consumption.
Shostak – “In the money economy, individuals’ time preferences are realized through the supply and the demand for money. The lowering of time preferences (i.e., lowering the premium of present goods versus future goods) on account of real wealth expansion, will become manifest in a greater eagerness to lend and invest money and thus lowering of the demand for money.”
“This means that for a given stock of money, there will be now a monetary surplus.”
“To get rid of this monetary surplus people start buying various assets and in the process raise asset prices and lower their yields. Hence, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure.”
“The converse will take place with a fall in real wealth. People will be less eager to lend and invest, thus raising their demand for money relative to the previous situation. This, for a given money supply, reduces monetary liquidity — a decline in monetary surplus. Consequently, this lowers the demand for assets and thus lowers their prices and raises their yields.”
PURPOSE OF INTEREST RATES
Resources are scarce and have alternative uses. Low interest rates send a signal to producers that resources are being freed up for use in future lines of production. But all they need to know is the lower interest rate makes expanding for future production affordable. Higher interest rates send a signal to producers that resources are being used for present consumption. The higher interest rate makes their plans to expand unaffordable and that is all they need to know.
Each individuals unlimited desire for specific goods, their time preference for specific goods, all of which are constrained by the scarcity of resources, their different uses, and the desire of individuals to produce specific goods based on whether they think it’s profitable is coordinated by interest rates. Interest rates coordinate production across time as long as they are determined by the market i.e. individuals time preferences. If set arbitrarily, interest rates distort the production process.
Ebeling – “Investment requires the availability and application of real resources and the distribution of raw materials and the use of a portion of the existing workforce to manufacture and at least maintain the capital goods – tools, machines, equipment, machinery and factory structures – finished and final goods and services produced and made available on the market that consumers want.”
“But all this takes time, repeated periods of production, through which goods are not to be done only once or even twice, but ever-so-every day, every week, every month, every year, there is a constant flow of them…..”
“If the resources, capital, equipment, and the work is not allocated and maintained, over and over again, to begin the process for the assembly of the next device, the output would shortly come to an end….”
“It must be the necessary savings in the economy to buy, implement and use the necessary raw materials, capital, equipment and workers so that each of the goods that are going on in the partially completed sequence can be brought to its final, usable form that is ready to be sold to consumers on the market.”
“Goods and services of all kinds are bought and sold with the help of money. But pieces of paper money, or even minted coins of gold or silver, can’t make the lack of real raw materials, capital, equipment, work or services disappear or less limited. Print out pieces of paper currency does not create out of thin air more coal, iron, or platinum. such paper money does not lead to a capital equipment miraculously falling from the sky. Nor do they materialize more working – age workers ready to be assigned to the desired job.”
THE ARTIFICIAL BOOM AND THE REALITY OF THE BUST
What happens when the Federal Reserve intervenes into this complex process? Fed policies usually result in artificially low-interest rates, and the injecting of electronically printed money into the system. The policy sends mixed signals through the market. The artificially low interest rate is a false signal that says there are more resources for expansion. Unfortunately people are still consuming at their present rate and haven’t started saving more for future production. The economy is being pulled in two different directions. The counterfeit money is demanding scarce resources for future production, but the structure of production is set up to meet people’s desires for present consumption. This is what happened with the housing bubble. The prices for scarce resources, labor, capital, and time were being bid up because they were being demanded for the expansion of new processes of production for future consumption. And at the same time these resources were being demanded for present consumption patterns that hadn’t changed. At some point there weren’t enough resources to go around and they were wasted when the bubble became unsustainable and collapsed.
Ebeling – “This balancing and coordinating function of the interest rates on the financial markets is undermined and distorted by central banking “activist” monetary policy that pushes for more money in the banking system. Since money is the medium through which the savings and investments carried out further amounts of money being made available for lending purposes creates a false impression that there are more savings to support longer and more time-consuming projects for investment than is actually the case. And artificially lower interest rates makes it seem as if these new or expanded investments in projects that are more profitable than they seem as if the higher market interest rates that prevailed in the financial markets.”
“….the investment boom stage of the business cycle will come to an end, and investment projects that can not be implemented or can not be profitably maintained if they are brought online. The downturn in the economy sets in. The imbalance between savings options and investment decision-making and the allocation and use of resources, capital and labor between the shorter and longer production processes become visible.”
“There must be a balance between supply and demand, prices, and wages, resources, capital and labor use between different sectors of the economy in order to more accurately reflect the post-boom realistic conditions on the market and profitabilities.”
“Jobs are temporarily lost, unsustainable and unprofitable investment projects must be written down or written out, and the illusory wealth positions will prove to be not as good or as high as they appeared in the previous boom phase of the business cycle.”
“What has happened over the last decade is the home, the stock market and the investment boom that was driven by the Federal Reserve easy money policies beginning in the year 2003 finally came crashing down in 2008-2009. Then, in the name of preventing the decline it mutates into a fearsome new deflation-driven “great depression”, the Federal Reserve has opened the monetary spigots for the last six years, setting up and running the same type of rise in the stock market, capital malinvestments, and the work of the misallocations that its monetary intervention had caused earlier in our century.”
“Now the Fed authorities want to rein in monetary expansion and “push” the interest rates up……. But if they do, this threatens to shake out the imbalance market relationships their own monetary policies have created.”
“This is how and why the roller coaster of the economic cycle continues to repeat itself, but each phase of the cycle varies in duration, and many special properties, depending on specific historical circumstances. The Federal Reserve’s own expansionary monetary policy, wets out for the boom that finally turns into a recession from which it is Fed authorities consider themselves as responsible to prevent or mitigate, that just sets in motion the next unsustainable boom of a new offset the monetary expansion.”
“So while the Federal Reserve has decided to keep its key interest rate near zero, it is only delaying the inevitable result of its own monetary policy, another needed economic correction that its actions will have generated but it will no doubt blame on the supposed “failures” of the market economy.”
The Federal Reserve and all Government bureaucrats don’t have a fraction of the knowledge that the market can bring to bear on any decision, but they have enough arrogance to think they do. As Hayek says their “pretense of knowledge” makes them think they can bring about results that aren’t possible because they fly in the face of the most basic economic principles.
Related Article – Thomas Woods Explains The Austrian Business Cycle Theory, at austrianaddict.com.
Related Article – Real Savings = True Credit, Printed Savings = False Credit, at austrianaddict.com.
Related Article – Federal Reserve Policies Cause Booms And Busts, at austrianaddict.com.
Related Article – Counterfeiting By The Federal Reserve, Although Legal, Still Results In Theft, at austrianaddict.com.
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