Who Owns The Interest Rate?

7 mins. to read

by Filipe R. Costa

The current financial world gravitates around low interest rates. When rates decrease, the price of both equity and bonds increase, as future cash flows become more valuable, making financial investors happy. It also becomes cheaper for consumers to buy all those items they have on their shopping list, as they can get extra credit at lower rates.

Businessman also become happier when rates fall, as they can finance their projects on more favourable terms than before. Those who are not really happy are savers, who see the incentive to save reduced as the yield on any kind of low risk investment becomes less attractive.

The interest rate is a single magic number under the control of central banks, which has the supposed ability to miraculously stabilise economic growth. So, when growth is very high, the central bank increases interest rates and when the economy is under recession, it just does the opposite. It naturally follows that central banks have a very important role in driving economic growth and eliminating the business cycle. But is that really true?

The rationale behind central bank intervention makes a lot of sense if we accept that the interest rate is an exogenous variable, in the hands of central banks, that is negatively correlated with growth and investment.

This justifies cutting rates to spur growth. The idea is reminiscent of the 1930s when Keynesian models were first introduced, even though they are now applied by central bankers under a modified version, which are commonly known as New Keynesian Models. Central banks make their interest rate decisions based on these models and believe they can control consumption and investment, and ultimately final output. So, in a certain way, by owning the interest rates, they also own the final output.

But, while there is no doubt that the interest rate is negatively related to consumption and investment, it sometimes isn’t easy to understand to what extent. The increase in investment and consumption derived from a cut in rates falls short of predicted values so often that central bankers just continue cutting and engage in unconventional monetary policy tools in the hope that the expected values are eventually achieved.

But playing with interest rates is their own business, as the ECB makes very clear:

A central bank’s core business is making it more or less attractive for households and businesses to save or borrow, but this is not done in the spirit of punishment or reward. By reducing interest rates and thus making it less attractive for people to save and more attractive to borrow, the central bank encourages people to spend money or invest. If, on the other hand, a central bank increases interest rates, the incentive shifts towards more saving and less spending in the aggregate, which can help cool an economy suffering from high inflation. This behaviour is not specific to the ECB; it applies to all central banks.

In order to justify the moves, in particular those aimed at cutting interest rates to negative levels, the ECB makes an interesting claim:

In a market economy, the return on savings is determined by supply and demand. For example, low long-term interest rates are the result of low growth and an insufficient return on capital. The ECB’s interest rate decisions will in fact benefit savers in the end because they support growth and thus create a climate in which interest rates can gradually return to higher levels.

But they got it all wrong!

A low interest rate is not the result of long-term low growth. In fact, in a market economy, it would be exactly the opposite. But under the current central banking regime the interest rate is not the result of market forces. The interest rate is now being determined by monetary policy and of course cannot be related to anything other than the central bank’s will, as very well depicted in the first excerpt written by the ECB.

But the best comment in the above statement is that the ECB claims low interest rates are good for savers and there is no punishment spirit involved. Claiming low rates are good for savers is as senseless as saying that conceding a goal is good for a football team. And if the idea is to reduce the incentive to save, then there is punishment involved.

In a market economy all prices are determined by the interaction between supply and demand, with the interest rate being the equilibrium price for the savings/consumption market, reflecting the time preferences of consumers.

When there is short-term preference, consumers prefer present consumption and thus consumption represents a larger proportion of savings and the interest rate rises. When there is long-term preference, consumers are willing to postpone consumption and consume a lower proportion of their funds, which leads the interest rate lower. The more valuable future consumption is, the lower the interest rate.

But that is not the case when “a central bank’s core business is making it more or less attractive for households and businesses to save or borrow”. When that happens, interest rates are no longer determined by the interaction of market forces but rather fixed by the central bank. So, if the central bank cuts interest rates, they are forced below their natural level (the free market equilibrium). Demand for investment funds will rise, without an accompanying increase in savings. Accordingly, the central bank will have to provide for the extra funds and expand credit. A boom is generated out of thin air and the extra wealth will go directly to consumption – savings are punished by the central bank.

The problem coming from fixing a lower interest rate is similar to the problem of fixing any other price – inefficiency will arise from it. The central bank is incentivising investment and consumption without a corresponding movement in savings. Future production (and consumption) has no backup and it is unsustainable in the long-term. It reminds me of the early days of the Common Agricultural Policy when inefficient outcomes were rewarded.

The unorthodox Austrian School of Economics states that when the interest rate is a free price, then a lower interest rate is the consequence of past accumulated savings.

This is in fact a good thing, not a bad thing, as claimed by the ECB. They claim that, as savings accumulate in an economy, the interest rate starts declining, which means that demand for loanable funds would rise, as would investment in long-term projects. These are projects that take time to develop and which increase the future capacity of the economy. Because investment relies on savings, in the future, a wealthier consumer will increase spending and these investments would prove valid and profitable.

Under such a setting interest rates play an important role, helping the efficient inter-temporal allocation of funds between consumption today and consumption tomorrow (through past savings). At the same time the interest rate also determines the allocation of investment between durable and non-durable goods. When the rate is high, more non-durable goods are produced and when it is low the preference goes in the direction of durable goods.

This idea is very interesting because it centres economic growth on the idea of sustainable growth driven by real savings. Instead of consuming everything today, a well-developed society will save part of its income for future consumption. The mainframe idea today is that savings are not important and an economy can grow through credit. This is an idea taken to the extreme by the Federal Reserve and the Bank of Japan, which can only end in tears in the future.

Today’s central banks just skip the savings accumulation part and go directly to the final stage.

They cut interest rates to drive investment higher such that more durable goods are produced for future consumption. But there is a drawback to this shortcut. Money is allocated to durable goods, when consumer preferences are for non-durable goods. In a few years, we will see economic capacity expanded but consumers will not be wealthy enough to increase spending to absorb the extra production. At that point we will enter recession and the central bank will again try its shortcut, which will distort the market once again… in a game that is not much different than a Ponzi scheme.

If we adopt the Austrian perspective, far from being the solution, the central bank just helps with the creation of a boom and bust cycle because it doesn’t allow consumers, savers and investors to take the right decisions. The managed low interest rate forces investors to take on longer-to-develop projects and savers into increasing their consumption. The economy can definitely grow for some time, but it will struggle at a future point when the consumer is perceived as not being able to increase spending to absorb all the goods produced.

Many of the initiated projects will be terminated and liquidated, generating unemployment and a fresh recession. Rather than being the problem, the recession is a needed adjustment to free up resources that were wrongly allocated in the past. At that point, unemployment grows, as the economy gets rid of past malinvestments. While this is not a mainstream view, it is one that is worth reflecting on, as it provides a good alternative view for the boom-and-bust we have been assisting during the last 30 years, a period that coincides with a more active monetary policy.

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