Economics Questions

Re: Inevitable rise in interest rates?

Minarchist — Wed, 22 Aug 2012 00:43:42 GMT

This is indeed true. But I understood your question or comment to mean what if the Fed purchased every U.S. government bond in existence on the open market. Maybe I understood?

Yes, that is what I meant. But if the Fed did this, there would still be new issuance coming out periodically, and so they'd still have to go about monetizing those in the usual way.

This is also technically true. But I would not think the Fed would want to impair any of its capabilities either.

And that may well be the case, who knows what they ultimately want to do. But I personally can't imagine that the Fed would sit by and watch treasury yields rise a level where the U.S. government had to default.

http://economics21.org/blog/low-interest-rates-conceal-bigger-national-debt

"At present, the average cost of Treasury borrowing is 2.5%. The average over the last two decades was 5.7%. Should we ramp up to the higher number, annual interest expenses would be roughly $420 billion higher in 2014 and $700 billion higher in 2020.

The 10-year rise in interest expense would be $4.9 trillion higher under "normalized" rates than under the current cost of borrowing."

...That's one helluva ARM.

Re: Inevitable rise in interest rates?

Think Blue — Wed, 22 Aug 2012 00:19:06 GMT

Minarchist:

Think Blue:
Then the government bond market would cease to exist, and the Fed would have to suspend open market operations.

Not exactly, as the Fed can't buy bonds direct from Treasury. They'd still have to go through the intermediaries they currently go through to indirectly monetize treasuries.

This is indeed true. But I understood your question or comment to mean what if the Fed purchased every U.S. government bond in existence on the open market. Maybe I [mis]understood? Edit: Corrected grammatical error.

Minarchist:
A central bank cannot face losses or bankruptcy in any meaningful sense. If the quality of the balance sheet deteriorates, all that does it impair the CB's ability to withdraw money from circulation through asset sales at a later date.

This is also technically true. But I would not think the Fed would want to impair any of its capabilities either.

Re: Inevitable rise in interest rates?

Minarchist — Tue, 21 Aug 2012 23:27:54 GMT

Then the government bond market would cease to exist, and the Fed would have to suspend open market operations.

Not exactly, as the Fed can't buy bonds direct from Treasury. They'd still have to go through the intermediaries they currently go through to indirectly monetize treasuries.

Let's assume private investors are demanding a nominal rate of 20% on a government bond. If the Fed target is a real rate of 0.25%, then the Fed would only need to push the government bond yield to a nominal rate of 19.25% (assuming an expected inflation rate of 19%).

There would no need for the Fed to push it all the way down to zero, as a nominal bond yield of 19.25% would suffice.

Let's say the Fed is really stubborn and wishes to push the nominal rate for the government bonds all the way down to near 0%. Through open market operations, the Fed can do this by bidding up all the bond prices.

Exactly.

Here is the problem. The Fed would be earning a negative yield to maturity, in real terms, of approximately negative 19% on the bond. In other words, the Fed would be buying the asset at a loss.

Depending on the accounting principle, this could result as a loss on the Fed's income statement or a write down of its assets.

A central bank cannot face losses or bankruptcy in any meaningful sense. If the quality of the balance sheet deteriorates, all that does it impair the CB's ability to withdraw money from circulation through asset sales at a later date.

Re: Inevitable rise in interest rates?

Think Blue — Tue, 21 Aug 2012 22:48:37 GMT

Minarchist:
What if the Fed is the entire bond market?

Is it impossible for the Fed to, say, monetize every oustanding treasury bill, note, and bond?

Then the government bond market would cease to exist, and the Fed would have to suspend open market operations.

Minarchist:
...whose going to borrow from Mr. Capitalist at 20% when they can borrow from Mr. Fed at 0.25%?

Let's assume private investors are demanding a nominal rate of 20% on a government bond. If the Fed target is a real rate of 0.25%, then the Fed would only need to push the government bond yield to a nominal rate of 19.25% (assuming an expected inflation rate of 19%).

There would no need for the Fed to push it all the way down to zero, as a nominal bond yield of 19.25% would suffice.

Let's say the Fed is really stubborn and wishes to push the nominal rate for the government bonds all the way down to near 0%. Through open market operations, the Fed can do this by bidding up all the bond prices.

Here is the problem. The Fed would be earning a negative yield to maturity, in real terms, of approximately negative 19% on the bond. In other words, the Fed would be buying the asset at a loss.

Depending on the accounting principle, this could result as a loss on the Fed's income statement or a write down of its assets.

Re: Inevitable rise in interest rates?

Minarchist — Tue, 21 Aug 2012 20:49:08 GMT

I think you have the causality backwards. The Fed, as a consequence of its monetary policy, causes the inflation rate to increase to 19%. To earn a 1% real interest rate, the market (those who buy bonds) will demand a bond coupon rate of 20%.

What if the Fed is the entire bond market?

Is it impossible for the Fed to, say, monetize every oustanding treasury bill, note, and bond?

...every corporate bond?

....every state and municipal bond?

...what if the Fed chooses to undercut every other bidder on the market?

...whose going to borrow from Mr. Capitalist at 20% when they can borrow from Mr. Fed at 0.25%?

Re: Inevitable rise in interest rates?

Minarchist — Tue, 21 Aug 2012 20:46:54 GMT

So your saying that if the market begins forcing the interest rates to 20%, that the federal reserve will just increase the inflation rate to19% to keep the interest rate at 1%?

That not how it works. The interest rate is the price of credit. It follows the laws of supply and demand like all other prices. When supply increases ceteris peribus, what happens? Prices fall. So if the Fed can create infinite supply.....

Re: Inevitable rise in interest rates?

Minarchist — Tue, 21 Aug 2012 20:43:16 GMT

Yes, interest rates WILL rise. Either by the Fed raising them or from my understanding, when the lenders realize the dollar's decline in purchasing power is no longer sufficient to sustain low interest rates, even if Fed tries keeping them low. Market forces always push back.

What determines interest rates? The supply and demand of loanable funds.

Does the Fed have the ability to create infinite quantities of loanable funds? Yes.

Therefore, does the Fed have the ability to suppress interest rates to any level for any length of time* it chooses? Yes.

The only debatable point is whether they will do this, not whether they can.

It is impossible to know with certainty what they will do, but I strongly believe that they will not allow rates to rise very much, because it would mean the collapse of the entire economic system whose maintenance is their reason for existing.

*Not actually "any length of time," as a policy of inflation will eventually render the inflators impotent when the currency becomes worthless. But short of hyperinflationary collapse, the Fed can do as it pleases to suppress interest rates.

Re: Inevitable rise in interest rates?

John James — Tue, 21 Aug 2012 20:05:29 GMT

Awiz90:
@Minarchist: Yes, interest rates WILL rise. Either by the Fed raising them or from my understanding, when the lenders realize the dollar's decline in purchasing power is no longer sufficient to sustain low interest rates, even if Fed tries keeping them low. Market forces always push back.

Whoa...maybe Mr. Minarchist should be asking the new kid questions, instead of trying to answer them.

Re: Inevitable rise in interest rates?

Think Blue — Tue, 21 Aug 2012 19:30:13 GMT

Awiz90:
So your saying that if the market begins forcing the interest rates to 20%, that the federal reserve will just increase the inflation rate to19% to keep the interest rate at 1%?

I think you have the causality backwards. The Fed, as a consequence of its monetary policy, causes the inflation rate to increase to 19%. To earn a 1% real interest rate, the market (those who buy bonds) will demand a bond coupon rate of 20%.

This coupon rate of 20% is not a problem for the U.S. government, since the dollar is losing value at a rate of 19% a year, so in reality, its real interest rate is 1%.

In essence, the U.S. government, through the Fed, is cranking out the printing press to reduce its indebtedness. Hyperinflation favors the debtors vs. the creditors.

In order to stop the hyperinflation, the Fed would have to raise nominal interest rate to a very high level. In this example, perhaps a number greater than 20%.

Re: Inevitable rise in interest rates?

Awiz90 — Tue, 21 Aug 2012 19:17:23 GMT

So your saying that if the market begins forcing the interest rates to 20%, that the federal reserve will just increase the inflation rate to19% to keep the interest rate at 1%?

Re: Inevitable rise in interest rates?

Think Blue — Tue, 21 Aug 2012 18:44:51 GMT

Awiz90:
5. Interest rates are driven back up to the market rate, the interest on our national debt skyrockets, interest rates are then forced back down and we repeat this whole mess over again.

If the Fed raises the interest rate to 20%, in nominal terms the interest payments could "skyrocket." However, this presupposes a very high rate of inflation.

In the meantime, the government is liquidating its own debt by increasing the money supply.

Let's say the inflation rate is 19%. This would calculate to a real interest rate of 1%, i.e. 20% - 19%. In real terms, the U.S. government could rollover its debt at a 1% real interest rate.

But keep this in mind, a 20% interest rate or higher would suppress any hyperinflation going forward. In other words, the interest rate (nominal or real) would return back to normal levels.

Re: Inevitable rise in interest rates?

Awiz90 — Tue, 21 Aug 2012 18:28:53 GMT

So I guess I can conclude that one of these, or all of these situtations may occur (other than we cut spending, balance, the budget, pay our dues, raise interest rates, end the fed, return to a sound currency):

1. We keep these boom and bust cycles going until we are so buried in debt and our dollar so weak that our currency hyper-inflates.

2. China denies us anymore credit due to inflation, and we look for other alternatives to fund our outrageous expenditures.

3. Interest rates are driven back up to the market rate, people default on their debt, banks fail, no bailouts, recovery begins.

4. Interest rates are driven back up to the market rate, people default on their debt, banks fail, they are bailed out once again prolonging the agony.

5. Interest rates are driven back up to the market rate, the interest on our national debt skyrockets, interest rates are then forced back down and we repeat this whole mess over again.

I keep going in circles. I wish I could find a more straight and narrow conclusion.

Re: Inevitable rise in interest rates?

Think Blue — Tue, 21 Aug 2012 18:10:24 GMT

Awiz90:
So we increase rates for a few years, driving us into another recession, then lower interest rates back down and create another bubble?

Yes. This is also known as the Business Cycle. The Austrian understanding about this is called the Austrian Business Cycle Theory (ABCT).

Awiz90:
How many times can we repeat this until the creditors of the United States' debt decide that it is time for us to pay up?

Indefinitely, or least until the U.S. government's unfunded obligations become so huge (e.g. Social Security and Medicare), the government would essentially default.

https://www.mises.org/daily/6159/Hyperinflation-Is-Not-Inevitable-Default-Is

Awiz90:
Will this happen all at once? Or is it only until China decides that they will no longer lend us anymore money?

Trends take a period of time to complete.

But even if they don't lend us more money, surely we can find another way to fund our expenses (i.e. printing money)

That's possible.

Re: Inevitable rise in interest rates?

Awiz90 — Tue, 21 Aug 2012 17:56:46 GMT

So we increase rates for a few years, driving us into another recession, then lower interest rates back down and create another bubble? How many times can we repeat this until the creditors of the United States' debt decide that it is time for us to pay up? Will this happen all at once? Or is it only until China decides that they will no longer lend us anymore money? But even if they don't lend us more money, surely we can find another way to fund our expenses (i.e. printing money).

Sorry if these are amateur questions, I feel like I keep running in circles when talking about our countries debt in relation to interest rates.

Re: Inevitable rise in interest rates?

Think Blue — Tue, 21 Aug 2012 17:44:06 GMT

Awiz90:
From my understanding, when interest rates eventually rise, it will create an immediate downpour of problems.

Yes.

Awiz90:
I can imagine that anyone with an adjustable rate loan will default and banks will surely fail as a result.

Yes.

Awiz90:
Are you saying that the interest rates will be driven back down so quickly that none of this will have enough time to occur? I'm confused.

No. If the Fed raises interest rates, there would be in Austrian terms a "liquidation of malinvestments." Then the Fed would lower interest rates to restart the economy, and repeat the whole process all over again. Think Paul Volcker in the 1970s:

http://en.wikipedia.org/wiki/Paul_Volcker