Interest Rates and Monetary Policy

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These days,
are two sets of statistics to monitor
if you are trying to avoid
losing money, let alone trying to make money. The first set is the
monetary statistics: the adjusted monetary base, M-2, and MZM (money
of zero maturity). M-3 is no longer published.

second statistic is the inverted yield curve
, which is the most
effective herald of a recession. How inverted is it? What is the
spread between the 90-day T-bill rate and the 30-year T-note rate?
The larger the spread, the more likely the recession.

The average
American has never heard of any of this. Most people go through
life in a kind of fog, confident that the experts back in Washington,
D.C., know what they’re doing. Even among those more sophisticated
groups of investors, who have heard of the Federal Reserve System
and who know that it is a central bank, few people actually monitor
these statistics on a regular basis. They, too, are confident that
experts at the FED know what they’re doing. But what if this confidence
is misplaced?

These days,
there is also considerable confusion about the direction of interest
rates. These days, rates are falling. Long-term rates have fallen
more than short-term rates have, which is a rare occurrence. Money
is tight. The monetary base is actually shrinking slightly. Yet
short-term T-bill rates and long-term T-bond rates have fallen in

If we look
at monetary policy from early 2001 until mid-2003, monetary inflation
expanded. Yet both short-term rates and long-term Treasury rates

What is going
on? If today’s tight monetary policy produces falling rates, but
loose monetary policy produced falling rates, what produces rising
rates? What constitutes cause and effect in interest rates?


A free market
rate of interest is a composite of three factors: the originary
rate of interest, the risk premium, and the price inflation or deflation
(rare since 1933) premium.

The originary
rate of interest is most important most of the time. It is the discount
that all people apply to the future. The future is less relevant
than the present in our plans. We value present goods more highly
than these same physical goods in the future. If someone wants to
borrow our money or an asset for some venture, we demand to be repaid
more than we are asked to lend. The benefits which the money or
asset would produce over the lending period will not be ours. So,
we want compensation. There are no free lunches in this life. Benefits
must be paid for.

Then there
is the risk premium. The lender may default, disappear, or break
the item. We may not be fully repaid at the end of the loan period.
We want compensation for the additional risk of loss. The more likely
the default, the higher the market rate of interest. Bad risks must
pay more in order to secure a loan.

Finally, there
is the price inflation or price deflation premium. Ever since the
creation of the Federal Reserve System in December, 1913, it has
been mostly an inflation premium. For money loans, the monetary
unit will depreciate in purchasing power over the period of the
loan. The lender is not in the business of giving away wealth. So,
the lender asks for compensation sufficient to offset the expected
loss of purchasing power, including any income tax on the increase
of money repaid.

In very rare
cases historically, such as 1930—36, price deflation threatens the
borrower. He must repay in money that may be worth more. So, he
refuses to pay a market rate of interest as high as the combined
originary rate and risk premium would otherwise mandate. This is
why interest rates on U.S. government ("riskless") T-bill
rates fell to barely above zero from 1933 through 1936.

World War II
was highly inflationary. Prices were fixed by law, but the money
supply shot up. Shortages were universal. Yet interest rates remained
at less than half of a percent until 1946. Deflation caused low
rates during the depression. Inflation caused low rates during the

How can this


When the central
bank expands reserves for the commercial banking system by purchasing
debt, the newly created money winds up as deposits in fractional
reserve banks. The banks then lend out money. The new money appears
to be the result of greater thrift by lenders. It isn’t. It is the
result of greater inflation.

Prices do not
immediately rise. The recession mentality is pervasive. Employers
remain cautious. They are in shell-shock. So, demand for business
loans is slow to respond to new money. The rising supply of loanable
funds is met by weak demand. So, interest rates fall or remain low.

As new projects
are launched, employment rises. The recession mentality fades. People
start spending money and borrowing money to buy things. Slowly,
the rate of price inflation begins to approach the rate of monetary

At this point,
the price inflation premium reappears.

Lenders demand
a higher rate for long-term loans.

If the central
bank’s policy of monetary inflation continues, long-term loans —
bonds, mortgages — also rise. So do short-term rates. But long-term
rates remain higher. The yield curve is positive: rising rates as
the maturity date extends. The risk of loss through rising prices
increases as the maturity date recedes.

in order to keep prices and long-term rates from rising, the central
bank must cease inflating so rapidly. It must cease buying government
debt. If policy is not reversed, the currency’s value will collapse.


Before the
bust, there is a transition period. Borrowers are still borrowing.
They do not perceive the threat: a falling economy, rising bankruptcies,
and unemployment, Like frantic buyers in an auction for new homes
in the final days of a housing bubble, so are borrowers at the end
of a boom. Interest rates shoot upward for one last move.

Then reality
sinks in. Debtors find themselves facing an economic slowdown. High
rates are strangling economic growth. Fear takes over.

We can see
this in the rate decline from 1929 to 1936. Prime bankers’ acceptances
(90 days) reached 5% in 1929. A year later, the rate was half that.
In 1931, it was 1.57%. In 1932, it was 0.62%. It kept falling. It
hit 0.15% in 1936.

What had happened?
Price deflation and the fear of stock market losses combined to
reduce the demand for loans. Lenders wanted safety, so they were
willing to lend short-term. They saw this market as less risky than
anything else out there.


Falling rates
occur during recessions. They begin to fall before the recession
appears. Long-term rates fall more than short-term rates. Lenders
want to lock in high returns. They think that short-term rates will
fall, which is common in recessions. When it comes time to roll
over the loan, lenders will receive lower interest on short-term
loans. So, they buy bonds. Long rates fall faster.

In the preliminary
phase of the boom, the fear of falling short-term rates recedes.
The boom will raise short-term rates. So, lenders stop buying bonds
and start buying short-term debt. They expect to be able to roll
over the loans at a higher rate in 90 days. At this point, the inverted
yield curve disappears. Long rates rise above short rates. The boom
will raise long rates faster than short rates because lenders fear
currency depreciation. They ask for a higher rate. Borrowers are
will to agree to this.

This is why
it is not sufficient to look at the direction of interest rates
as a way to forecast the economy. You must look at the money supply,

When long rates
are falling faster than short rates, and where the money supply
is increasing at a lower rate than a year ago, you can safely conclude
that the next phase of the economy will be recessionary. Interest
rates are falling because lenders are seeking safe returns.

In the transition
phase from boom to bust, which does not last long, prices are rising
faster than the money supply is. The stock market is still climbing
in anticipation of rising consumer demand and rising corporate profits.
This is the last hurrah of the boom phase.

Bond market
investors see what is coming before stock market investors do. They
grow pessimistic before stock market investors do. The inverted
yield curve appears in the midst of rising prices, including stock
prices. The economic boom looks solid. So does the stock market
boom. But the bond market’s investors think otherwise. They lock
in high long-term rates.


So, it is not
enough to look at the direction of interest rates and conclude that
the Federal Reserve is pursuing hard money or soft money. The tendency
is to interpret a falling Federal Funds rate as a sign of monetary

To see which
cause is dominant — inflation or deflation — you must look at the
money supply figures. They are important for revealing which phase
of the economy we are in. Falling short-term rates do not tell us.
Falling rates in general do whisper "recession ahead,"
and long-term T-bond rates that are below short-term T-bill rates
are not whispering. They are raising their collective voices.

would be wise to listen.

Having listened,
you would be wise to ask yourself:

will my situation be a year from now?"

24, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 19-volume series, An
Economic Commentary on the Bible

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