Hello!
I have a couple questions hopefully someone can help me out with. First, how exactly is inflation related to below-market interest rates, and how does raising rates reduce inflation? Can't a central bank raise rates AND print money at the same time?
Also, sometimes I hear that "bond vigilantes" will force rates up whether the Fed wants them up or not, exactly what is the mechanism for accomplishing this? Thanks for any help!
"First, how exactly is inflation related to below-market interest rates, and how does raising rates reduce inflation? Can't a central bank raise rates AND print money at the same time?"
It depends whether you are talking about price inflation or monetary inflation. Monetary inflation (expansion of the money supply) leads to price inflation (prices can go up for other reasons, but monetary inflation is by far the most dominant reason especially over the long run). I think it's important to look at both forms of inflation because both affect interest rates in different ways.
When new money is created (monetary inflation) through the loan market as credit, it increases the supply of loanable funds and thus ceteris paribus lowers the price for borrowing those funds, i.e. the real interest rate. Ultimately this new money will lead to rising prices and a higher demand for money; prices are higher so in order for people to buy the same basket of goods they once bought, they need to hold higher cash balances, i.e. their demand for money increases. This pushes real interest rates back up to their previous level.
Price inflation (likely as a result of monetary inflation) affects nominal interest rates to the extent that said price inflation is expected. In other words, if a lender believes prices will rise, he factors that into the nominal rate of interest charged over the relevant period in order to ensure he gets his desired real rate of return (If he wants 5% greater purchasing power by the end of the year and he expects prices to rise by 5%, he will charge roughly 10%).
Thanks for answering!
I see what you are saying here but I am still unclear. For instance, we often here about the persistently low interest rates and drastic expansion of the money supply being responsible for the coming inflation monsoon on the horizon. So are interest rates and money supply controlled independently? Or does one cause the other? Also, for example, I have heard that Volcker drastically raising interest rates in the early 80s is what saved the dollar and "broke the back of inflation". How did raising rates here stop inflation?
"When new money is created (monetary inflation) through the loan market as credit, it increases the supply of loanable funds and thus ceteris paribus lowers the price for borrowing those funds, i.e. the real interest rate. Ultimately this new money will lead to rising prices and a higher demand for money; prices are higher so in order for people to buy the same basket of goods they once bought, they need to hold higher cash balances, i.e. their demand for money increases. This pushes real interest rates back up to their previous level."
This seems to imply to me that new money will have a net unchanged effect on rates?
Thanks!
Interest rates aren't directly set by the Federal Reserve (except for the discount rate, but as I understand it, that is usally based of the Federal Funds Rate), meaning the Board of Governors doesn't just dictate the rate. They set a target rate and then use Open Market Operations to increase or decrease (usually increase) the supply of money. So when people say the Fed lowered or raised rates, they don't literally mean the Fed set the rate, only that they are targetting a new rate by increasing or decreasing the money supply. In other words, interest rates are manipulated by the money supply.
Prices likewise are heavily influenced by the money supply. In general: the more money the, higher the price level. So when someone says Volcker raised rates and broke inflation, what actually happened was that he decreased the money supply (or decreased the rate at which money was being created) which caused interest rates to rise and the price level to "disinflate" (meaning it didn't go down, it just went up at a decreasing rate). The important causation isn't between interest rates and prices but separately between the money supply and interest rates, and the money supply and prices. Does that help?
"This seems to imply to me that new money will have a net unchanged effect on rates?"
In the long run, ceteris paribus, that's correct. Of course I'm not really discussing the effects in short run, nor how long the short run lasts just the steps involved. In addition in the real world, nothing is ever really ceteris paribus. You could also throw the ABCT into the analysis, but I'm keeping it fairly simple.
the way i understand it the bond vigilantes were traditionally those that demanded more interest for bond purchases. either they would sell their holdings or refuse to buy new treasuries at the rates offered. in this environment however, the fed combats bond vigilantes by simply buying its own debt effectovely forcing down interest rates on bonds and increasing bond value. when the fed runs out of this QE tool, I suspect the bond vigilantes will have a field day, requiring higher rates to purchase debt or selling off their holdings. right now the bond vigilantes tool is to short or sell the dollar since the fed is forcing bond yields down.
The bolded might help the most for your particular question, but these all provide great insight into what interest is and what it does, and how the manipulation of it affects the economy.
Articles:
The Phenomenon of Interest
The Nature of Interest
Hayek vs Mises on the Theory of Interest
Role of Interest in Entrepreneurial Calculations
Natural and Neutral Rates of Interest in Theory and Policy Formulation
Video:
Capital and Interest - Robert P. Murphy
Only the Austrians Understand Interest Rates
Production: The Rate of Interest and Its Determination [Jeffrey M. Herbener]
Capital and Interest (by Hans-Hermann Hoppe) - Introduction to Austrian Economics
Pattern Coordination and the Theory of Interest - Robert P. Murphy
Economics 101: Capital, Interest , and Profit - Murray N. Rothbard
"Interest rates aren't directly set by the Federal Reserve (except for the discount rate, but as I understand it, that is usally based of the Federal Funds Rate), meaning the Board of Governors doesn't just dictate the rate. They set a target rate and then use Open Market Operations to increase or decrease (usually increase) the supply of money. So when people say the Fed lowered or raised rates, they don't literally mean the Fed set the rate, only that they are targetting a new rate by increasing or decreasing the money supply. In other words, interest rates are manipulated by the money supply."
Ah yes ok this is the crux of what I was trying to get at! Ok so the Fed doesn't just declare an interest rate, they use the money supply to try to set an interest rate. This would be why below market interest rates would be tied to increases in the money supply and thus increases in prices. Right?
Ok thanks for the help!
The Federal Reserve system doesn't directly control interest rates. In fact, it only targets the interest rate on inter-bank over-night loans (the federal funds rate). It does this by either buying or selling government bonds in the open market (known as open market operations). When it buys bonds it puts upward pressure on the demand for such bonds which, in turn, lowers its interest rate and, similarly, when it sells bods, it puts downward pressure on the demand for such bonds and elevates interest rates (inverse relationship between the demand for bonds and interest rates). The money used to buy such bonds, during (expansionary) open market operations, is created ex nihilo by the FED and therefore constitutes an expansion in the supply of money (and when the FED sells bonds it drains the system of base money, which has a deflationary/disinflationary effect). In other words, an expansion in the supply of money necessarily means an arbitrarily reduced interest rate (all other things equal). So no, the central bank, at least in the U.S., cannot simultaneously raise the federal funds rate and print money.
Also, sometimes I hear that "bond vigilantes" will force rates up whether the Fed wants them up or not, exactly what is the mechanism for accomplishing this?
The FED, in a very indirect way, can only influence the demand for longer term bonds (remember, it only directly targets and manipulates the interest rate on federal funds, an extremely short-term debt instrument, through the use of open market operations); it does not directly control it. The demand for longer term bonds falls when the market expects inflation somewhere in the future which, in turn, puts upward pressure on yields (inflation reduces the real rate of return for bond holders which is why they demand higher yields/nominal returns).
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