Interest Rates and The FED

If you've been keeping up to this point, give yourself a big pat on the back: you're over the hump, and due a well deserved congratulations. Let's face it. Central banking is boring. Monetary stastics, and economics in general, are boring. I do my best to insert snide comments and sarcasm to keep it entertaining, but for most people, this just isn't their cup of tea. But if you've gotten this far, its is pretty much downhill from here. Now we can begin to get into the fun and interesting stuff. By slogging through to this point, you are not fooled by the popular statistical definition of inflation based on price movements. You now understand the system of transactions used by the FED to manipulate the money supply and the phony accounting system used by fractional reserve banking better than probably 99% of the population. Right now, you have the tools to answer the inflation/deflation question better than most all of your peers. You are beginning to push the limits of my own understanding. From here on out, you will be seeing a lot of rehashing and review, as you already know the mechanics of the system and we will now be turning our attention towards how these manipulations interact with the "real economy." Did I leave out a lot of details? Oh heck yes! No one could possibly give a thorough look such an in-depth topic with three measly blog posts. And frankly, I don't know it in enough detail to do the topic justice. But you're not going to start running a bank yourself tomorrow, are you? Maybe you have even bigger goals, like actually working for a central bank or setting up your own fiat monetary system. In that case -- a pox upon you! For the rest of us decent folk, this is more or less what we need to know to gain a reasonably solid understanding of the grand scam that enslaves us to corporate, government, and banking interests so that we can do our best to squeeze out from under them, keep more of what we earn by our own honest sweat, and take care of the ones we love. By understanding what has gone wrong and why, we can hopefully make better decisions in the future if and when this system falls apart and we have the opportunity to build a new one. Assuming we get that far, of course. We will know the lies when we inevitably hear them, and we will have an idea of how to answer them. And that is really the point of all of this. But just in case you really want to understand central banking in such a depth as to render yourself a giant pulsating forebrain capable of going head-to-head with the combined demonic spirits of Alan Greenspan, Paul Volcker and other Ghosts of Central Banking Past, then Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto is the book for you. I haven't read it just yet. For my own part, I'm just going to plow through and make do with practical stuff. How the FED Manipulates Interest Rates This sounds distinctly like we're going to talk about some new monetary machination of the FED, doesn't it? Didn't I just say we were through with that? Actually, if you've been reading this series of posts up to this point, you already know how the FED manipulates interest rates. It manipulates interest rates the same way that it manipulates the money supply: by buying and selling assets. Under a central banking regime, manipulation of the money supply and manipulation of interest rates are one and the same thing. They are the same phenomenon. When you hear it announced that "the FED lowered interest rates" or "the FED raised rates today," technically, this isn't true. Pretty much all the FED does is buy and sell assets. The FED targets a particular interest rate for a particular banking transaction: the overnight lending rate. What is the overnight lending rate? When a bank shuts down for the day, it has to make sure that it has met reserve requirements. Remember: a bank is legally required to have 10% of its deposits secured as reserves. This can be either as vault cash, or reserves held with a member bank of the Federal Reserve System. If a bank comes up short, it must get the funds from somewhere. This is an opportunity for banks which have not come up short to make a little money. They extend overnight loans to the banks which need money. The interest rate of this loan is the rate targeted by the FED. By purchasing or selling assets, the FED can influence the reserves of lending banks, increasing or decreasing the supply of money available for these types of loans, or covering for banks requiring a loan and thus reducing demand. By fiddling with supply and demand in this market, it can pretty well dictate the interest rate. So, the whole purpose of all those asset purchases and sales is to manipulate this obscure interest rate. It is also sometimes called the Federal Funds rate. Interest Rates: Who Cares? So, why do this? Who really cares? Remember back to our first discussion, when we talked about the different ways to define inflation? The present definition of inflation used by non-Austrians, the one based on changes in price levels, derives from a certain mindset about the way the world works that hasn't actually been around all that long, at least here in the US. It is based on the idea that the basic functions of society can be manipulated at will by government technocrats. For some reason, which I do not claim to be able to explain, a philosophy took hold near the end of the 19th century and the beginning of the 20th that embraced a sort of scientific ordering of government and society by enlightened technocracy. The simpleminded notion that an ounce of gold was an ounce of gold and the reliance on tradition and rules of ethical behavior was replaced with the idea that science and engineering could "do better than that." Modern, enlightened man's intellectual prowess allowed him to design his own economic and social systems with properties that were superior to those that had been based on barbaric codes and ancient superstitions rather than being rooted in scientific reality. Or something like that. It was perceived that turning over the regulation of our society to enlightened individuals and institutions was better than either messy democracy or sclerotic rule of law. The movement led to the election of men like Woodrow Wilson, a professor and university president, and Herbert Hoover, a talented and accomplished mining engineer, instead of the usual parade of lawyers, generals, and the like. This was the period that saw the rise of communism and fascism. It was also the period that saw the rise of the FED. Central banking had been tried sporadically across the West for several centuries, but within a few decades of the turn of the 20th century, it became universal. Perhaps it was wrapped up in the whole Progressive movement. Perhaps it was an outgrowth of the "age of reason," and overconfidence in the scientific advances of the time that brought it about. I don't know the answer. Perhaps Fran, or one of the other co-conspirators, or an enlightened commenter could enlighten me. But it happened, and it overturned much common sense that we could desperately use today. Most people still buy into this myth when it comes to economic thought, and especially when it comes to monetary theory, even those who reject other forms of Progressivism. Statistics describing the economy are taken to be more important than actual, tangible facts, and goals more important than rules of fair play. Hence we prefer a "flexible" paper currency system instead of a rigid, "barbaric" gold coin standard. "Cost of Living Adjustments (COLA)" or "adjustment for inflation" are taken to be fairer and more accurate determinations of our pensions rather than something like simple payment in a fixed quantity of gold. That last one just sounds strange, doesn't it? But really, why should it? In embracing the Progressivist mindset, we trust the management of our money and our future to politicians and professional government statistics-mongers. You know, the same ones that run the DMV and get caught breaking the very rules they were hired to enforce. Do we really trust them more than fixed payment in gold? Modern economists and government statistics-mongers are obsessed with statistics like the CPI and consumer confidence. They treat these statistics as an engineer would treat his gauges and data readouts on some complex mechanical system. They tell our economic engineers what is going on in the economy so that they can pull the right economic lever to make things work better. Or so the thinking goes. The validity of those statistics depends, of course, on the validity of the theory used to derive them, not to mention the honesty and integrity of those whose task it is to produce the statistics. We have already peered through several gaping holes with respect to inflation statistics and laughed at the economists caught with their pants down on the other side. I'll leave the question of the integrity of government bureaucrats and politicians for you to answer on your own. In their efforts to engineer economic policy, they could care less about things like the money supply. Money supply is taken to be more of a practical consideration, as in, whether or not there is "enough money" to facilitate economic exchange in a given region. The ethical component of the function of money and the consequences of manipulating it fall by the wayside. They are far more concerned about interest rates because they see interest rates both as critical statistical descriptors of the economy and as tools for manipulating it. Manipulating interest rates is the primary goal of FED policy, as these rates are critical determinants of economic behavior. Interest rate manipulation is the preferred tool for economic engineering by our central bank. Money supply fluctuations are merely a means to an end. This is why you will hear a story on every business channel when the FED "changes the interest rate," but rarely do they ever talk about the volume or direction of actual "open-market operations," which is the term used to describe the buying and selling of assets by the FED. Maintaining the "correct" interest rate is taken to be more important than the creation or destruction of money required to achieve it, because of the dominance of the mindset that the supply of money does not matter, because we believe in the lie of inflation through price changes. The broader market chooses to talk of the FED in terms of interest rates because it believes the money supply does not matter. I chose to introduce FED operations in terms of the money supply because I know that it does. The money supply is more than simply something to manage in the pursuit of a desired outcome. Interest Rates and the Economy Unfortunately, interest rates are no mere statistics, and though modern economists may have a hint of their significance, in their penchant for social engineering they also treat them as something violable that can be changed arbitrarily to suit their needs. In discussing just exactly what an interest rate is, once again, we find that economists cannot agree on a simple, fundamental topic. Theories to explain interest rates abound. If you take the time to read them, most will sound pretty reasonable. But they can't all be right. Whichever you happen to choose to believe isn't really all that important, at least from a mechanistic point of view, although it does matter a great deal from a theoretical point of view. For our purposes, the important thing is to understand what happens when the rate is manipulated. That being said, I'll go through the Austrian definition, just so you'll know. Austrian theory describes the interest rate as an expression of "time preferences." Interest is taken to be compensation for the use of saved funds over a period of time, e.g. the price a saver demands for delaying the consumption which he could otherwise enjoy today. An individual with a "high time-preference" for money would require more compensation for the use of his funds than an individual with "low time-preference." Of course, if an individual with a low time-preference can find a higher interest rate, he will, but that isn't the point here. The point is this: the availability of funds for lending is dependent on time-preferences. At some point, as time-preference increases, funds simply become unavailable. Potential lenders will not part with their money temporarily below a certain price. This is the price of their delayed gratification, and it is a brick wall. Individuals with varying time preferences interact with borrowers in the marketplace to determine exactly what the going rate of a loan will be in each individual case. In a society skewed towards individuals with lower time preferences, interest rates will tend to be lower than in a society skewed towards individuals with higher time preferences. Time preferences, and therefore interest rates, broadly determine an important partition within the economy: the allocation of resources between consumer goods and capital goods. By allocating a smaller fraction of funds towards immediate consumption, a low time-preference society will leave a larger fraction of unconsumed goods in the marketplace and place a greater level of funds available for investment and entrepreneurship. Demand is shifted away from consumer goods and towards capital goods, accelerating the rate of capital accumulation and wealth formation versus a high time-preference society. Here we see the motive behind the actions of the FED. By artificially suppressing the interest rate, the FED does the same thing: shift demand towards capital goods and away from consumer goods by using an expansive monetary policy. How does this work exactly? Interest Rates and the Debt Market Remember: under a regime of fractional reserve banking serviced by a central bank, manipulating the money supply and manipulating interest rates are the same thing! By buying assets, the FED makes more money available to banks for lending, but not to consumers for consumption. By multiplying the money supply, fractional reserve banking makes more money available for lending, but not for consumption. This counterfeit money, the product of crooked accounting and money-printing, competes with the existing money supply as entrepreneurs seek out loans for their business ventures. This drives down the interest rate that entrepreneurs must pay as an increasing pile of "savings" bids for their promised interest payments. Monetary expansion acts as a subsidy for debt markets. Bond prices are driven by interest rates. With lots of money competing for willing borrowers, interest rates are driven down and bond prices are driven up. Low interest rates are indicative of high levels of demand and plenty of available cash in the bond market. Not only does borrowing look cheap and relatively safe, if you are a lender, lending looks like a safe bet as well. After all, there is a plentiful supply of other bidders with money in their pockets, just like you. You won't collect as much in interest, but the price of your asset, the bond, is protected by a continual stream of new money pushing present interest rates down, competing for your asset and protecting its nominal value. So long as this remains the case, there is a ready market for your asset should you decide to sell. Interest rate suppression encourages taking on high levels of debt and punishes saving, as we have seen all too clearly in recent times. It also encourages entrepreneurs to go on a borrowing spree and take on new projects directed at satisfying future consumer demand that otherwise would not have occurred. What Could Possibly Go Wrong? This is actually a good idea, right? By suppressing the interest rate, we are helping capital formation and wealth accumulation, and therefore making people richer, aren't we? We are encouraging risk-taking, and entrepreneurship, and economic growth, and all that other good stuff, even according to this so-called Austrian theory that certain nutcase Eternity Road economic contributors subscribe to, are we not? Not exactly, as you might have guessed. There are a whole host of problems that are initiated when the interest rate gets suppressed, however these would be better addressed in a discussion on the business cycle. But since I'm sure that my intrepid readers are all worked up for answers and just can't wait for the next post, I'll give a quick hint or two about how and where things start to go wrong. Note that all of the arguments I have used are short term arguments. In the long run, all that lent money eventually makes its way into the deposit accounts of consumers, so expanding the money supply will eventually increase interest rates as price inflation becomes visible and savers demand a higher interest premium for the use of their money. "Stimulating growth" through suppression of the interest rate by monetary expansion has only a temporary effect. To keep it going, the expansion must continue at an accelerating rate as the new counterfeit money competes with an ever larger quantity of existing money. Note also that suppression of the interest rate sends a false signal. It is another example of a discrepancy in time expectations, similar to the discrepancy between long term lending by banks coupled with short term expectations of money availability by depositors. The lower interest rate sends the signal that capital is plentifully available and larger investment projects, especially projects with a longer time horizon, can be undertaken profitably. However, it should be clear that such resources are not available; after all, the fact remains that the interest rate is manipulated. Consumers are not willing to delay gratification to the degree that interest rates would suggest, but this does not become evident until some time has passed and those interest rates begin creeping up, rendering all those nice looking projects unprofitable. Today, it looks like businesses should run headlong into risky new ventures. Tomorrow, when they need to roll over their debts and can't get anything close to yesterday's interest rates, it becomes plain as day that they have made big mistakes. Sales funded by cheap credit dry up. Inventories build as products go unsold. This is to say nothing of the price distortions and bubble activities that are initiated by interest rate suppression and credit expansion. But I shall leave that for a future post on the business cycle. Conclusion The FED manipulates the interest rate in the same way that it manipulates the money supply. It, and most other economists, focus on interest rates rather than the money supply because they believe their own lies: that inflation is a product of rising prices, that economies and societies can be engineered on a whim, that their self-aggrandizing, delusional theories are correct, that God may safely be mocked. Suppressing interest rates requires expansion of the money supply, which flows into the banking system and results in lending at rates that do not reflect market realities. Debt levels increase, and risky new entrepreneurial ventures begin to spring up throughout the economy. And so begins the business cycle.