Interest Rates and Monetary Policy

These days, there 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.

The 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 2006.

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 fell.

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 war.

How can this be?


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 inflation.

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.

Eventually, 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, too.

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 loosening.

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.

You would be wise to listen.

Having listened, you would be wise to ask yourself:

“What will my situation be a year from now?”

November24, 2006

Gary 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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