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Individual Time Preferences, Not the Central Bank, Determine Real Interest Rates

On Wednesday, November 2, 2022, the Fed raised the target for the policy rate by 0.75 percent, to 4.00 percent, for the fourth time in a row. Fed chairman Jerome Powell hinted that the policy rate target is likely to be lifted further ahead. For most economists and commentators, the Fed’s monetary policy is the heart of the interest rate determination process.

By popular thinking, whenever the central bank raises the growth rate in the money supply through the buying of financial assets such as treasury bills, this pushes the prices of treasuries higher and their yields lower. The popular thinking labels this as the monetary liquidity effect. This effect is inversely correlated with interest rates.

Furthermore, an increase in the money supply after a time lag strengthens economic activity, and this pushes interest rates higher. Note that we have here a positive correlation between economic activity and interest rates.

After a much longer time lag, the increase in the growth rate of money supply exerts an upward pressure on the prices of goods and services. Once prices begin to move higher, the inflation expectations effect emerges. Consequently, this is starting to exert a further upward pressure on the market interest rates.

Hence, by popular thinking, liquidity, economic activity, and inflation expectations are seen as key factors in the interest rate determination process. Note that this process is set by the central bank’s monetary policies, which influences monetary liquidity. The monetary liquidity effect in turn gives rise to two other effects.

Note that the popular explanation for the interest rate determination is derived from observations and not from an economic framework that “stands on its own feet.” In this sense, the popular theory of interest rate does not explain, but only describes.

Moreover, the followers of this framework of thinking are likely to have a hard time to explain the interest phenomena in a world where the central bank is absent.

Time Preference and Interest Rates

Contrary to popular thinking, interest rates are determined by individuals and not by central bank monetary policies. We believe that monetary policies of the central bank only distort interest rates.

For most individuals, maintaining their lives and well-being is the ultimate goal. To stay alive, an individual must consume goods in the present, which means that the person will assign greater importance to a basket of goods in the present than to the same basket in the future. The premium that individuals assign to the basket of goods in the present versus the same basket of goods in the future explains interest.

Consider a case where an individual has just enough resources to keep himself alive. This individual is unlikely to lend or invest his paltry means. The cost of lending or investing is going to be very high—it might even cost him his life if he were to consider lending a part of his means. Once an individual’s wealth starts to expand, however, the cost of lending or investing diminishes. Allocating some of his wealth toward lending or investment is going to undermine to a lesser extent the individual’s life and well-being at present.

From this we can infer, all other things being equal, that anything that leads to the expansion in the wealth of individuals will likely result in the lowering of the premium of present goods versus future goods, reducing interest rates. Conversely, factors that undermine real wealth expansion will likely increase the premium of present goods versus future goods, increasing interest.

Responses to changes in wealth in terms of time preference are not automatic. Every person, based on his ends, decides how much wealth will be allocated for the present consumption versus the future consumption.

Also, note that by popular thinking, changes in economic activity are positively associated with interest rates. However, if the increase in economic activity is due to wealth expansion, there likely would be a decline in time preferences with lower interest rates following, contradicting popular notions.

Interest Rates and the Increase in Money Supply

When money created from “thin air” is injected into the economy, it creates an exchange of something for nothing. Recipients of injected money now can divert wealth from wealth generators to themselves.

Like counterfeiters, recipients of money created from nothing become wealthier than before the increase in money happened. This means that the receivers of money can now increase the purchases of various assets thus pushing their prices higher and their yields lower. Note, however, that the exchange of nothing for something weakens the process of wealth generation.

When the pool of wealth expands, interest rates are expected to decline, but a declining pool of wealth will raise rates. When the central bank attempts to counter the rising interest rate trend by means of injecting monetary liquidity, this makes things worse, as there will be an oscillation of interest rates with a rising trend.

The oscillations emerge because the central bank exerts downward pressure on interest rates by emphasizing liquidity. The decline in the pool of wealth, however, pushes the rates up—hence the oscillation.

Raising Interest Rate Is the Wrong Policy for Countering Inflation

Interest rates fluctuations in a free-market mirror changes in consumer preferences regarding the present versus future goods. Thus, if consumers have increased their preferences toward goods in the future versus goods at present, this will be mirrored by a decline in the market interest rates.

Businesses wanting to be successful must allocate resources toward the buildup of a suitable infrastructure to be able to increase the production of consumer goods sometime in the future. Whenever the central bank manipulates market interest rates it actually falsifies consumers’ instructions to businesses. As a result, businesses generate wrong capital infrastructures not in line with consumers’ actions, leading to misallocation of resources and economic decline.

Contrary to popular thinking, a higher interest rate policy of the central bank does not remove the resource misallocation because of the previous low interest rate policies. A higher interest rate policy also tampers with market interest rates, continuing the misallocation.

In turn, the new central bank policies continue to impoverish wealth generators by keeping the resource misallocation processes intact. (Central banks continue to generate nonproductive activities that weaken wealth generators). Hence, a higher interest rate stance of the central bank within the framework of a declining pool of wealth undermines the pool of wealth further thereby deepening the economic recession.

Contrast this with a policy that closes the loopholes for the generation of money out of “thin air.” Curbing these policies undermines nonproductive activities by obstructing the diversion of wealth from wealth generators, ultimately increasing the pool of wealth. The enlargement in this pool shortens the period of the economic slump, while closing new money creation slows general increase in prices.

Conclusions

Most economic commentators believe that market interest rates are determined by changes in monetary liquidity, economic activity, and inflationary expectations. An increase in monetary liquidity pushes interest rates lower. Increases in economic activity and inflationary expectations push interest rates higher.

This framework depicts individuals as unconscious entities and claims interest originates from outside factors and not from within individuals. This is erroneous thinking that leads to economic disaster.