By Frank Shostak*
A common conception is that the central bank is a key factor in the determination of interest rates. In this way of thinking, the key role of the central bank is to make sure that the so-called economy is placed on a trajectory of stable economic growth and stable inflation. If for whatever reason the economy appears to deviate from the specified trajectory, then it is the responsibility of central bank policy to ensure the economy remains on this path. This is attained, so it is held, by means of influencing the short-term interest rate, in the US the federal funds rate.
The central bank influences the short-term interest rates by influencing monetary liquidity in the markets. While asset buying by the US Fed raises the money supply, its selling of assets produces the opposite effect. Thus, by buying assets the Fed adds to the monetary liquidity, thereby lowering rates, while by selling assets the exact opposite is taking place.
Popular thinking also suggest that long-term rates are the average of current and expected short-term interest rates. If today’s one year rate is 4 percent and the next year’s one-year rate is expected to be 5 percent, then the two-year rate today should be 4.5 percent ((4+5)/2=4.5 percent). Conversely, if today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 3 percent, then the two-year rate today should be 3.5 percent (4+3)/2=3.5 percent.
Time Preference and Interest Rates
It is individuals’ time preferences rather than the central bank, however, that are the key to the interest rate determination process. What is it all about?
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 to lend 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 toward lending or investment is now going to undermine his life and well-being to a lesser extent. 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
According to Carl Menger:
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period….All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.2
From this we can infer, all other things being equal, that anything that leads to the expansion in the real wealth of individuals should give 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 should lead to a higher interest rate. Increases in real wealth tend to lower individuals’ time preferences whereas decreases in real wealth tend to raise them. The link between changes in real wealth and changes in time preferences is not automatic, however. Every individual decides how to allocate his wealth in accordance with his priorities.
Demand for Money and Time Preference
The lowering of time preferences, i.e., the lowering of 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 nonfinancial—and to lower their demand for money. In the process, this raises asset prices and lowers their yields, all other things being equal.
Observe that whilst the increase in the pool of real wealth is likely to be associated with a lowering in the interest rate, the opposite is likely to take place with a fall in the pool of 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. With all other things being equal, this will manifest in the lowering of the demand for assets, and thus lowered prices and raised yields.
What Will Happen to Interest Rates If the Money Supply Increases?
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. This will likely set in motion a greater willingness by these individuals to purchase various assets. It leads to the lowering of the demand for money by these individuals.
This in turn bids the prices of assets higher and lowers their yields. At the same time an increase in the 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. The consequent weakening in the real wealth formation process sets in motion a general rise in interest rates.
This implies that an increase in the growth rate of money supply, all other things being equal sets in motion a temporary fall in interest rates. This decline in interest rates cannot be sustainable because of the damage to the process of real wealth generation. A decline in the growth rate of money supply, all other things being equal, sets in motion a temporary increase in interest rates. However, over time, the fall in the money supply sets the foundation for a strengthening in the real wealth formation process, which sets in motion a general fall in interest rates.
We can thus see that the key for the determination of interest rates is individuals’ time preferences, which manifest through the interaction of supply and demand for money. Note that the central bank has nothing to do with the underlying interest rates determination. The policies of the central bank only distort where interest rates should be in accordance with time preferences, thereby making it much harder for businesses to ascertain what is really going on.
Stagflation and Interest Rates
How likely is it that interest rates will be affected in a situation where economic activity is declining while price inflation is strengthening? What we have here is stagflation, i.e., a strengthening in price inflation and a decline in economic activity. The key factor behind stagflation is the previous strong increases in money supply, which undermine the pool of real wealth. Strong increases in money supply result in an exchange of nothing for something, which weakens the process of real wealth formation. The weakening of the pool of real wealth in turn weakens real economic growth.
At the same time, increases in the money supply weaken the purchasing power of money. Hence, we have here a weakening in economic activity and a general increase in price inflation. A weakening in the process of wealth generation due to the strengthening in the money supply growth rate increases individuals’ time preferences, i.e., the underlying real interest rates go up.
In response to the emerging economic slump, the central bank enters to lift the money supply growth rate further. This pushes asset prices higher, thereby lowering their yields. After a time lag, though, this increase in the money supply and resultant increase in price inflation is likely to prompt the Fed to reverse and tighten its interest rate stance. This means that, relative to the previous situation, the Fed is likely to reduce its buying of assets. Consequently, upward pressure on interest rates is likely to emerge.
However, this upward pressure on yields should only be temporary, since a tighter monetary stance is actually good news for the formation of real wealth. After a time lag, this is likely to lower individual time preferences and work toward the lowering of real interest rates.The 1970s is a great example of stagflation. After closing at 2.7 percent in June 1972, the yearly growth rate of the US Consumer Price Index (CPI) had jumped to 12.3 percent by December 1974. The yearly growth rate of industrial production, which had closed at 11.6 percent in December 1972, had plunged to –12.4 percent by May 1975.
Note that a strong increase in the growth rate of money AMS (Austrian Money Supply) from 2.7 percent in May 1970 to 9.6 percent in February 1973 was an important cause behind the strong acceleration in price inflation from June 1972 to December 1974. At the same time, this strong increase in the momentum of AMS had likely undermined the pool of real wealth (see chart). This likely real wealth erosion, coupled with a decline in the yearly growth rate of AMS from 9.6 percent in February 1973 to 4.1 percent in December 1974, weakened the momentum of industrial production.
Are We Heading for Stagflation?
That the yearly growth rate of US AMS stood at 74 percent at the end of December 2020 (see chart) raises the likelihood that a strong increase in price inflation is ahead.
As a result of past reckless fiscal and monetary policies, the pool of real wealth could be declining. If this is the case, it is possible that the monetary pumping will not be effective in terms of getting the economy out of the slump. This raises the likelihood of stagflation ahead.
Observe, though, that the Fed increased the fed funds rate target from 5.5 percent in June 1972 to 11 percent in June 1974. By December 1974 the target had been lowered to 8 percent.
Note that the Fed pursued a tighter interest rate stance until June 1974 while the momentum of industrial production was declining. In contrast, currently there is not a high probability that the Fed is going to tighten its interest rate stance soon, the major reason being that while an increase in price inflation is probable sometime in the future, a major consideration of the Fed is likely to be that the US economy still remains vulnerable to the paralyzing effects of covid-19 policy such as the lockdowns.
- 1.Ludwig von Mises, Human Action: A Treatise on Economics, scholar’s ed. (1949; Auburn, AL: Ludwig von Mises Institute, 1998), p. 97.
- 2.Carl Menger, Principles of Economics, trans. James Dingwall and Bert F. Hoselitz (Auburn, AL: Ludwig von Mises Institute, 2007), p. 153–54.
Source: This article was published by the MISES Institute