Inflationomics

Reader's Questions Answered

Questions:  Why can’t the Fed keep interest rates low?  How does the market drive them back to market value?

Answers:  Interest rates are paid to people to forbear from consuming their savings now and instead lend the money to someone else for a period of time.  Some people think of interest as the wages of savings or loaned money.  This payment necessarily takes place in a currency or money.  Thus, the question arises, which currency are we talking about?

In the United States, we use the U.S. dollar which is controlled (printed/electronically supplied) by the Federal Reserve Bank (the central bank).  Other currencies are controlled by other central banks and may have different rates of interest.  Also, because the U.S. dollar is the world’s reserve currency, there is much more demand for it than any other currency in the world and the Fed can get away with printing a much larger supply of currency than can a country like Zimbabwe.  Still, there is a limit to how many U.S. dollars the Fed can print before the supply exceeds the demand and the value of each dollar declines.

If this occurs (supply greatly exceeds demand), we have inflation and interest rates will reflect the inflation rate.  That is a market phenomenon that can prevent the Fed from keeping interest rates low.  The Fed won’t be able to stop the market from incorporating the inflation rate into the interest rate and thus raising the rate in the long run.

Another possible reason why the Fed may not be able to keep interest rates low is that there is competition among currencies (and not just government-managed currencies).  Now we are seeing digital currencies (a market driven alternative), as well.  The more rationally and reasonably a currency is managed, the more people may be willing to use it.  Rationally and reasonably means that it is market sensitive/driven.  The further from a market-driven currency it becomes, the less people will maintain their faith that it will continue to function as a currency and eventually, they will abandon using it.  Again, using or not using a currency is a market phenomenon/choice.

I should also mention that the Fed has a monopoly on supplying U.S. dollars and that, as long as it does, and people choose to use U.S. dollars, the Fed will be able to keep interest rates lower than it could if people were free to choose a different currency in which to function.  At some point, however, if enough people choose to flee the U.S. dollar, the Fed will lose control of its ability to manipulate interest rates, and whatever new currency/money is adopted will necessarily drive interest rates back to a market rate.

Presently, many central banks are experimenting with negative interest rates, where savings are taxed by the banks rather than being paid interest.  This creates an incentive for savers to withdraw their savings from the banks (thus financially damaging banks and chasing savers away from those currencies in which negative interest rates are used), and finding alternatives in which to put their savings.  Time will tell, but my guess is that more savings will find their way into tangible assets, crypto-currencies, and gold and silver, which, in turn, will increase in price relative to the savings-punishing currencies.  And, lastly, those currencies are merely making themselves less desirable all the time and thus limiting their useful lives.  In short, the market (people) will choose the currency that pays a market rate of interest in the long run.

Robert F. Sennholz

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