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Source link: http://archive.mises.org/13392/the-unlimited-power-of-suppressing-the-interest-rate/

The Unlimited Power of Suppressing the Interest Rate

July 27, 2010 by

The uncomfortable truth is this: central banks, as monopoly producers of base money, have the capacity to enforce any yield level they wish to see in credit markets. FULL ARTICLE by Thorsten Polleit

{ 26 comments }

guard July 27, 2010 at 7:13 am

Thanks you for this enlightening information. Not very encouraging though…

Hugo July 27, 2010 at 9:39 am

Very good explanation on how the Fed controls the long term rates.

I would love to read an extended version on the last part.

J. Murray July 27, 2010 at 9:46 am

Aren’t banks allowed to indefinitely roll over short term Fed loans to provide for long term loans?

Gerry Flaychy July 30, 2010 at 8:50 pm

Short term in the case of Fed loans usually means overnight loans. It is used to allow a bank to comply with its reserve requirement. They are emergency loans.

So the idea of ‘roll over’, or ‘to provide for long term loans’, doesn’t apply to those loans.

Pat G July 27, 2010 at 10:43 am

It must be true that the government cannot wantonly increase its debt. An increase in government bond sales at too rapid a rate would inevitably lead to default and the prospect for bankruptcy for practically all banks that are stuck at the end with the hot potato bonds. Thus, the subsidy to banks due to the low central bank interest rates is limited by the willingness of banks to accept the bonds. This in turn is depends on price inflation expectations. So long as the subsidy is in the form of readily marketable bonds, most bankers are unlikely to give this much thought until it is too late (i.e., until government bond prices suddenly plummet due to the prospect of government bankruptcy).

However, I don’t think that hyper-inflation and the prospect of the breakdown of the banking system is the likely result of the current policy. More likely, I think, is that price inflationary pressures will rise if and when banks begin to increase their lending of excess reserves to finance actual business investments (as opposed, for example, to refinancing mortgages or buying government bonds). The question is: how will the Fed respond to such inflationary pressure. If it is smart enough to gradually raise reserve requirements, it will blunt a recovery but lead to a more orderly adjustment to the fact that real taxes, real government spending, and the monetary base are now higher. If it allows the price inflation, there will be further distortions in the market and further pressures for the kinds of intervention in the financial system that have already greatly hampered the ability of “market forces” to bring a recovery.

billwald July 27, 2010 at 5:08 pm

Seems to me that an increased money supply will not cause inflation unless/until it filters down to the retail level and drives up retail prices. The Treasury just invented two trillion dollars out of thin air but it has not changed retail spending. It wasn’t created by auctioning US debt thus hasn’t increased the US national debt. It is probably sitting in Swiss banks doing nothing except making our owners richer.

A. Viirlaid July 28, 2010 at 4:23 pm

It must be true that the government cannot wantonly increase its debt.

I cannot agree that the above MUST be true — it is not true IMHO. If Central Bankers “play along” and continually increase the money supply via “Quantitative Easing” to “facilitate” so-called economic “recovery”, then it most certainly is not true.

It wasn’t created by auctioning US debt thus hasn’t increased the US national debt.

It most certainly does increase US Debt — please read my explanation as follows:

The FED prints net-new money in droves.

That money is lent to the banking sector at a 0.25 percent annual interest rate.

Those banks “invest” in 10-year Treasuries paying say 2.5 percent annually.

The Federal Government gets this net-new money from The FED in this manner.

As much as it wants, in essence.

The Federal Government spends that loaned money on some goods and services — maybe not haircuts, but let’s say on planes and other war goods, on the salaries of military personnel, on social services, on transfers to the states, and so on.

Sooner or later the net-new money from The FED gets to the private sector via this channel.

Sooner or later it will cause price inflation — if you really believe Federal Government CPI and PPI stats, then this price inflation has not yet arrived — but are you really SO gullible as to believe in those stats?

michael July 27, 2010 at 11:57 am

Correct me if I’m wrong…

but when a central bank (the Fed) lends money to a favored customer at a very low interest rate, isn’t that irrelevant when the customer wants to re-borrow the money? That is if I, michael megabank, borrow a billion from the Fed at 1% and the loan is due this month, isn’t the Fed at liberty to say “”mm, it’s a new ballgame now. If you want to keep that money it’ll cost ya more over the new term”?

Also, isn’t it the case that the rate at which this megabank borrows money has absolutely no relationship to the rate it will charge when it lends it out? That is, if the bank’s uncertain we’re really in a recovery mode, can’t they borrow at one and lend at five?

If so, the rate at which the bank borrows Fed funds bears little relationship to the actual uses to which the money is put once it enters the economy.

When the Fed loans this favored customer the money it has not actually entered the economy. It’s only potential capital, a reserve being held. Once it gets lent out, then it becomes real money, in the sense that it does actual work. So all the lending in the world a central bank does doesn’t alter events one iota… not until the bank receiving the money decides to lend it to someone.

Right?

tralphkays July 27, 2010 at 12:39 pm

One of the problems inherent in any governmental intrusion into the marketplace is the effect those intrusions have on the decision making process of individuals. Government policy is necessarily based on observations of peoples actions in the previous time period, and presumes that implementation of that policy will result in either no change in peoples actions or in a specific predictable change. This presumption is entirely false. The current situation of banks taking advantage of fed policy to build up reserves without increasing lending (and the money supply) is an example of this presumptions failure. Bankers have responded in a way that the government did not anticipate, and they are very likely to respond to future moves by the government in ways the government does not anticipate. This is true of all actors in the marketplace, we are not the automatons that the government assumes we are. Their precise control over the economy is an illusion, and their precise control over the money supply is an illusion.

michael July 27, 2010 at 1:14 pm

“The current situation of banks taking advantage of fed policy to build up reserves without increasing lending (and the money supply) is an example of this presumptions failure.”

So then, the practical effect of lending so much magic money to banks who then don’t re-lend it to businesses is identical to the practical effect of not lending those banks any money at all?

I see. Then when the loans come due they should ask for their money back– by asking a higher interest rate on an extension of the loan. The practical effect of such a tactic would be to make those banks more prudent. And retire some of those Fed issues.

tralphkays July 27, 2010 at 1:31 pm

Not at all, the practical effect is that the fed has less control of the money supply than before. By providing banks with excess reserves they have put a great deal of control over the money supply in the hands of bankers. Bankers who are not behaving as the government assumed they would.

J. Murray July 27, 2010 at 3:20 pm

That value definition is used when the economist fails to understand what money is. Money is not value, it’s a ruler to measure value. Imagine if the measurement pound (or kilogram for our non-American audience). It’s a measure of weight that is static and constant. Imagine the chaos if we were allowed to inflate the definition of the unit of weight. People would continually think that they are losing weight and improperly adjust their lifestyle around it. Redefining the weight measurement won’t cause you to lose weight.

The same thing happens with money. By assuming money has value, an incentive is created to produce more of it,which breaks the measurement component. If the quantities of everything fluctuate, we no longer have a reliable ruler. Pricing cannot be accurately gauged if the ruler is constantly changing.

Further, even the use of the term inflation denies the value measurement logic. What is inflating? The raw quantity of money, not the value. If value measurement were the case,we would call it deflation.

tralphkays July 27, 2010 at 3:32 pm

Money is not a ruler. It is not a constant measure of value that can be compared over time the way a unit of weight can, EVEN IF THE MONEY SUPPLY STAYS CONSTANT. At any given moment the value of everything on the market is determined by the supply of and demand for everything in the market. Value of anything can only be compared if exactly the same conditions prevail at both times. This would mean the exact number of people making the exact same value judgements in the exact same place about the exact same goods and services. Highly unlikely to say the least.

billwald July 27, 2010 at 5:14 pm

Agree 100%. Money functions as a tool with which to add apples and oranges, dollars and euros. Money also functions as a universal IOU. IOUs are not investments.

Jonathan Finegold Catalán July 27, 2010 at 2:36 pm

Michael,

but when a central bank (the Fed) lends money to a favored customer at a very low interest rate, isn’t that irrelevant when the customer wants to re-borrow the money? That is if I, michael megabank, borrow a billion from the Fed at 1% and the loan is due this month, isn’t the Fed at liberty to say “”mm, it’s a new ballgame now. If you want to keep that money it’ll cost ya more over the new term”?

This can be considered a contractionary monetary policy, where the Federal Reserve dissuades banks from holding large stocks of Federal Reserve notes by raising interest rates.

Also, isn’t it the case that the rate at which this megabank borrows money has absolutely no relationship to the rate it will charge when it lends it out? That is, if the bank’s uncertain we’re really in a recovery mode, can’t they borrow at one and lend at five?

If the Federal Reserve reduces the rate at which it lends to banks, and thus banks take on a greater amount of Federal Reserve banknotes, one could deduce that an increase in bank reserves will cause the bank’s interest rates to decrease, as well. If the supply of loanable funds increases, the price for that money will fall assuming the demand for loanable funds remains the same.

In the event of a liquidity trap, which we can roughly define as a period of time in which an increase in the supply of money has little impact on the volume of loans, an increase in loanable funds by part of the Federal Reserve will not effect the interest rate at which banks lend at, until the period of uncertainty (which causes the liquidity trap) ends.

Bradford DeLong makes that point when defending the Federal Reserve’s monetary policy against Krugman’s criticism (although, I still hold that they both say the same thing; DeLong is just being a tad bit pedantic). Yes, current monetary policy may not be very effective at stimulating the economy (which is in tune with Austrian theory, since that money is actually not being put into circulation), but once that money is lent out then it will have real effects on the economy (DeLong, of course, assumes these effects will be good; an Austrian would argue otherwise).

greg July 27, 2010 at 1:17 pm

When comparing the relationship between long and short term interest rates, you really need to look at the real rate of interest by factoring in the inflation at the time.

tralphkays July 27, 2010 at 1:33 pm

It is not possible to do that, there is no way to determine what the inflation rate is in the first place.

J. Murray July 27, 2010 at 1:51 pm

Yes there is. Inflation is the change in overall money supply. We can track how much new money entered the system. The change in prices due to mechanics of supply and demand are not inflationary or deflationary. Inflation is purely a phenomenon based on the creation or destruction of money. Please note, savings (ie voluntary removal of money from circulation) is not deflation as the money still exists, just being retained for future utilization.

tralphkays July 27, 2010 at 2:40 pm

Only if you define inflation and deflation solely as changes in the money supply. (a definition I support, by the way) The more common usage of the term inflation however is tied up with the idea of being able to compare the “value” of money at different times. That is not possible. Likewise it is not possible to quantify the specific effect of a money supply change on interest rates.

billwald July 27, 2010 at 5:17 pm

Yes, but the consumer doesn’t care about the overall money supply. He cares about how many hours he must work to pay the bills. Marx wasn’t ALL wrong.

J. Murray July 28, 2010 at 6:54 am

From the consumer end, maybe. You’ve forgotten that an inflationary system continually erodes the employee’s efforts. When his last year’s efforts may have purchased a toaster, he will find that his prior year’s efforts insufficient to purchase the same toaster. This creates an improper incentive in favor of immediately spending everything produced to avoid the continued loss of relative value over time.

Further, on the production end, the quantity of money remaining static is very important as new money distorts pricing higher, creating the illusion that there is increased demand that needs to be filled when the reality could be the opposite. This is the malinvestment aspect Austrians talk about.

The real answer to how much money is the right amount – whatever it is right now. The best thing we can do for our economy is to make sure the money supply doesn’t grow.

Pat G July 28, 2010 at 11:00 pm

Don’t forget, J., that one must always account for how the money enters the economy. To write of an inflationary system without including something about where the money enters takes one’s eye off of the entrepreneur role, which aims to profit from making correct predictions. The inflationary system you have in mind seems to be one in which the new money, no matter how it enters, is totally unpredictable. This is not very realistic.

R. Thomas Harding July 27, 2010 at 2:47 pm

It seems to me that a severe distortion in interest rates occurs when the Fed eagerly buys up treasury bonds that, if otherwise purchased on the open market, would command a higher return in consideration of the debt problems in this country. A distortion of fiscal reality.

In addition, with the Fed’s policy of paying interest to banks on their excess reserves and keeping those reserves at the Fed, there exists a bribe to banks to have their cake but not let the market enjoy it–another way of keeping the flow of funds out of the market and controlling inflation. Good for the Fed–bad for the economy.

A. Viirlaid July 28, 2010 at 4:57 pm

… with the Fed’s policy of paying interest to banks on their excess reserves and keeping those reserves at the Fed, …

R. Thomas Harding, I don’t think all of the Banking Sector’s excess reserves are in The FED’s coffers. Please see my response above to Pat G and to billwald.

The problem is not that the Banking Sector does not have money to lend, it is that the banks are very busy repairing their own capital ratios (and very busy paying bonuses to their executives) — and they are having very real problems identifying good credit risks for retail lending on Main Street.

Main Street has been literally crucified and partially devoured by the Money-Pulations of The FED over the last 2 decades.

Aggregate Demand (if you believe that there is a separate ‘aggregate’ Demand-entity apart from all the ‘disaggregated’ individual demands that are out there in the Real Economy) has been sacrificed by past actions that The FED is desperately now trying to revive. (Good Luck!)

Because The FED has so screwed up the Real Economy, by so distorting that Economy with its Interest Rate Money-Pulations in the past, so that no one knew how to most efficaciously ‘grow’ that Economy, we now have a Main Street that has to re-sort itself into some semblance of a living thriving expanding sector once again — that will take time. Just look at the adjustment that one sector, Housing, has to go through, before it can contribute, and not subtract, from GDP on an ongoing basis.

Sure, in the past, The FED could —— seemingly quite effectively, and seemingly, quite ‘harmlessly’ —— goose The Real Economy time-after-time as it and “The Committee to Save the World” thought they were doing “Good” with their faulty policies — but in reality, that Goosing was terribly distorting and “misadjusting” to the Real Economy over time.

As Ted Turner has said, the time has come to Pay the Piper. And we are going to pay BIG-TIME. Payback Time has only just begun.

By the way, I love your comment about:

It seems to me that a severe distortion in interest rates occurs when the Fed eagerly buys up treasury bonds that, if otherwise purchased on the open market, would command a higher return in consideration of the debt problems in this country. A distortion of fiscal reality.”

This is a charade —— the only thing that The FED knows how to do.

Pat G July 28, 2010 at 11:26 pm

As I see it, the demand for money balances is rising so fast that it is soaking up all of the increase in money supply that is occurring as a consequence of the fed’s financing of additional government spending. The so-called money multiplier is, at the moment, not a significant factor in the determination of the prices of consumer goods. The Fed and the government have contributed to this high money balance demand through policies that that introduce a variety of different kinds of uncertainty and that threaten long-term investment profit prospects.
This, by the way, is part of my answer to A.Viirlaid.

A. Viirlaid July 29, 2010 at 10:28 am

I agree with you Pat G.

Money Velocity drops during severe recessions and depressions.

So-called Price Inflation is driven not only by Money Supply but by Money’s Velocity (turnover) in the Economic-Financial System.

So we should not be surprised to observe that price inflation is slow to manifest itself.

My comment was to point out that money is getting into the system even if some substantial part of their reserves is held by the banks at The Federal Reserve.

Not only are regular banks making loans to Uncle Sam, so too is The FED with its monetization policies, which it euphemistically refers to as “Quantitative Easing”. That is, The FED also purchases bonds (Treasuries) from the Department of the Treasury.

You are quite right IMO as are the other contributors to suggest that the current economic environment is not as conducive to price inflation from such Money Supply increases as would be the case in more normal times.

If only it were so, that is, that price inflation would result from such intervention. In such a case people like Dr. Ben Bernanke would be “happy” that the Economy is responding. In such a case, he would be able to start withdrawing some of the inordinately large ‘stimulus’ that has been unleashed upon the System.

As it is, such withdrawal will likely be delayed, perhaps until it is too late, that is, until Stagflation is unleashed and truly well-entrenched.

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