Consequences of Current U.S. Monetary Policy

Interest rates serve many purposes in a free market economy, making artificial manipulation all the more destructive.

1. The interest rate signals societies' time preference for capital goods, intermediate and end stage goods. In other words, it is a signaling mechanism relayed to the entrepreneur regarding the amount to invest and in what area in the structure of production to allocate capital. Distortions in the interest rate causes even great entrepreneurs to missallocate capital, which would have been allocated efficiently otherwise, preventing productive jobs from being created, among other things.
2. Market determination of interest rates would prevent asset bubbles due to the fact that when abnormal profits are recognized by potential investors they try to exploit these profits, which causes the demand for money to rise as more and more entrepreneurs seek out these abnormal profits. But as the demand for money rises, interest rates in a free market will necessarily rise. In other words, the abnormal profits have a decreasing net present value as interest rates rise. This rate also has implications regarding consumption and savings.
3. The natural market mechanism is to save your way out of recessions, promoted by the high cost of money. In a recession, the demand for money increases as well (people tend to be cautious when they are uncertain about their financial future, thus driving up the demand for money). So in recessions/depressions, interest rates should be higher than normal, not lower than normal. This is basic economics as savings generates investment or "capital formation" which is what creates viable and productive jobs.
4. As high interest rates drive down peoples' time preference, the process of capital formation begins immediately.

Interest Rates In a Centrally Planned Economy: What The Fed Is Doing

1. Drive the boom-bust cycle as we have seen recently in 2001 and 2008. It was the artificially low cost of borrowing that caused the missallocations of capital (as entrepreneurs interpretation of societies time preference was distorted).
2. The Prolonged period of cheap money bred a society that didn't hold savings in high regard. The consumer culture the US has transformed into was a direct result of this anti-saving mentality. The savings rate went negative for a while but is being prevented from reaching a level that will generate capital accumulation because of our 0% interest rate policy.
3. Individuals took out loans which wouldn't have been granted to them had the market determined the prevailing rate of interest.
4. The economy has fallen and can't get up. The savings rate continues to remain dangerously low, even in the current environment. It had picked up for a while, but the most recent GDP report showed a record 71% was composed of consumer spending. In other words, the opposite of what we need to have a real recovery.
5. Investments taken on now, will only serve to cause further capital missallocation.
6. To keep rates low the Fed is injecting money into the system, having multi-billion treasury auctions, engaging in interest rate swaps with the ECB, monetizing hundred of billion of debt, all in an attempt to keep rates low.
7. The long end of the curve (which helps determines the cost to service our interest on the public debt) is also being held down artificially, but this will only lead to skyrocketing rates (look at Iceland).

The Federal Reserve has to get out of the way before it is too late. By letting the market determine the interest rate(s), this will not only allow for the quickest recovery possible, but also take hyperinflation off the table.

Comments

[chap08:]

"So in recessions/depressions, interest rates should be higher than normal, not lower than normal. This is basic economics as savings generates investment or "capital formation" which is what creates viable and productive jobs."

This is not basic economics, this is a basic error. Investments are only partly funded out of domestic savings. They can also be funded by overseas savings and this is what has happened in America. We have had a massive and consistent capital inflow over many years. We have had, and continue to have, more investment funds than we know what to do with (that's where our asset bubbles come from by the way). We do not need more funds for investment - we need some viable things to invest them in.

Your other basic error is not understanding the impact of interest rates on investment decisions. If you want more investments, as you imply, then don't put rates up. There are many ways to understand this, but lets mention two:
1. The higher the rate, the less profitable the investment. The less profitable the investment, the less investment made.
2. Get out in the real world. Go and run a business as I have. Then you will understand.

Nov 04 11:00 AM

[Mad Hedge F...:]

xcg First of all, let me warn you that reading this paragraph is a complete waste of your time. Still interested? There is chatter about that the Fed is considering a surprise interest rate rise at its upcoming meeting. After all, where can they go from zero, but up? They could be emboldened by the recession ending Q3 GDP of 3.5%. The bond market is certainly telling us that rates should go higher, with yields on ten year Treasuries jumping from 2.45% to 3.40% since March. Unfortunately, this is the usual kind of gibberish you get from pundits and prognosticators , who, at a loss for any explanation of the real reasons for Friday’s melt down, resort to making stuff up out of thin air. US industrial capacity utilization is terrible, while unemployment is rising to record levels. Banks still aren’t lending to small businesses, the largest job creators in the country, because they are about to get hit with an onslaught of bad commercial real estate loans. Sure, commodity prices have doubled or tripled this year. But this happened because investors were desperate for any alternative to the sickly dollar, not because there is huge underlying demand by end users. This is one of the reasons why I have been ringing the alarm bell about all long positions for the last three weeks. So I can say with complete confidence that the chances of an interest rate hike are less than zero for the foreseeable future. This discussion did have the one benefit that it did enable me to fill this space in my newsletter.

Nov 04 01:10 PM

[derryl:]

chap,
Don't be so hard on the young fella. He has his equations right but neglects the real world details that you filled in. It is actually excessively low domestic interest rates that led to the excessive capital formation of US$ among foreigners that is finding its way back into the US system to inflate the asset bubbles.

The money began its life as US mortgages. Artificially low mortgage rates led to excessive demand for real estate. When the mortgage money was used to buy real estate it became incomes in the hands of the real estate, construction and home products industries. Those incomes contributed to excess demand for foreign oil and Chinese consumer goods. Oil exporters and the Chinese then recycle their dollars into US investment vehicles like Treasuries and stocks. So it really is low domestic interest rates that generated the excess demand for investments. As you put it,

"We do not need more funds for investment - we need some viable things to invest them in."

Amen to that.

Nov 04 01:25 PM

[chap08:]

derryl, I know what you are saying, but actually he doesn't have his equations right. He has the beginner level equation which ignores transactions on the capital account. I make a point of this because people at this beginner level keep making the same basic error. They never stop to wonder how we achieved so much over investment in treasuries and housing while running such a low domestic savings rate.


On Nov 04 01:25 PM derryl wrote:

> chap,
> Don't be so hard on the young fella. He has his equations right
> but neglects the real world details that you filled in. It is actually
> excessively low domestic interest rates that led to the excessive
> capital formation of US$ among foreigners that is finding its way
> back into the US system to inflate the asset bubbles.
>
> The money began its life as US mortgages. Artificially low mortgage
> rates led to excessive demand for real estate. When the mortgage
> money was used to buy real estate it became incomes in the hands
> of the real estate, construction and home products industries. Those
> incomes contributed to excess demand for foreign oil and Chinese
> consumer goods. Oil exporters and the Chinese then recycle their
> dollars into US investment vehicles like Treasuries and stocks.
> So it really is low domestic interest rates that generated the excess
> demand for investments. As you put it,
>
> "We do not need more funds for investment - we need some viable things
> to invest them in."
>
> Amen to that.

Nov 04 04:31 PM

[untrusting ...:]

Hey Mad,
You ask where can interest rates go from zero? My preference would be a negative 5%. I would love it if they pay me 5% to borrow a bunch of money and I would be happy to do so under those conditions. Please write your Fed governor and politican to see if you can make that deal for both of us. Surely both of us deserve to get rich just like GS and da boyz, and the negative interest rates should help both of us.


On Nov 04 01:10 PM Mad Hedge Fund Trader wrote:

> xcg First of all, let me warn you that reading this paragraph is
> a complete waste of your time. Still interested? There is chatter
> about that the Fed is considering a surprise interest rate rise at
> its upcoming meeting. After all, where can they go from zero, but
> up? They could be emboldened by the recession ending Q3 GDP of 3.5%.
> The bond market is certainly telling us that rates should go higher,
> with yields on ten year Treasuries jumping from 2.45% to 3.40% since
> March. Unfortunately, this is the usual kind of gibberish you get
> from pundits and prognosticators , who, at a loss for any explanation
> of the real reasons for Friday’s melt down, resort to making stuff
> up out of thin air. US industrial capacity utilization is terrible,
> while unemployment is rising to record levels. Banks still aren’t
> lending to small businesses, the largest job creators in the country,
> because they are about to get hit with an onslaught of bad commercial
> real estate loans. Sure, commodity prices have doubled or tripled
> this year. But this happened because investors were desperate for
> any alternative to the sickly dollar, not because there is huge underlying
> demand by end users. This is one of the reasons why I have been ringing
> the alarm bell about all long positions for the last three weeks.
> So I can say with complete confidence that the chances of an interest
> rate hike are less than zero for the foreseeable future. This discussion
> did have the one benefit that it did enable me to fill this space
> in my newsletter.

Nov 09 06:51 PM

[enviro111:]

Drive the boom-bust cycle as we have seen recently in 2001 and 2008. It was the artificially low cost of borrowing that caused the missallocations of capital (as entrepreneurs interpretation of societies time preference was distorted).

response:
There is always a boom and bust cycle even in Planned economies. The cycle is the 'heartbeat' of economics. Elimination of it is like a "flatline" on an EKG machine. If the government is trying to eliminate the cycles then they will kill the patient.


The Prolonged period of cheap money bred a society that didn't hold savings in high regard. The consumer culture the US has transformed into was a direct result of this anti-saving mentality. The savings rate went negative for a while but is being prevented from reaching a level that will generate capital accumulation because of our 0% interest rate policy.

response:
Low interest rates have led to drop in savings and an increase in consumption. What else could possibly happen? To a Keyensian, this is a wonderful outcome. Savings are bad. Consumption is good. If some savings are good for an individual, then why aren't they good for society? The Keyensian paradox.


Individuals took out loans which wouldn't have been granted to them had the market determined the prevailing rate of interest.
The economy has fallen and can't get up. The savings rate continues to remain dangerously low, even in the current environment. It had picked up for a while, but the most recent GDP report showed a record 71% was composed of consumer spending. In other words, the opposite of what we need to have a real recovery.

response:
Real recovery is built on savings. Either the US population makes the savings or a foreign entity makes them and gives them to us. Because we were America, we could count on this now for 40 years. However, it might be over. Keyensian theory will be shown for what it really is: Quackery.


Investments taken on now, will only serve to cause further capital missallocation.

response:
Artificially low interest rates will create artifically bad investments. We live in an age of bubble economies. In fact, it seems that American's cannot live without bubbles. Everytime we burst one, we seek to create yet another one.


To keep rates low the Fed is injecting money into the system, having multi-billion treasury auctions, engaging in interest rate swaps with the ECB, monetizing hundred of billion of debt, all in an attempt to keep rates low.
The long end of the curve (which helps determines the cost to service our interest on the public debt) is also being held down artificially, but this will only lead to skyrocketing rates (look at Iceland).

Iceland is getting off easier than the United States will get off.

Nov 25 01:45 PM