Thursday, 1 October 2015

Central Banks Don't Dictate Interest Rates

Guest post by Frank Shostak

According to mainstream thinking, the central bank is the key factor in determining interest rates [and interest rates haven’t been this low since 3000 BC]. By setting short-term interest rates the central bank, it is argued, through expectations about the future course of its interest rate policy influences the entire interest rate structure. (According to expectations theory (ET), the long-term rate is an average of the current and expected short-term interest rates.)

Note that in this way of thinking, interest rates are set by the central bank; individuals have almost nothing to do in all of this and just mechanically form expectations about the future policy of the central bank. (Individuals here are passively responding to the possible policy of the central bank.)

Time Preference Is the Driving Force

But the great Austrian economists Carl Menger and Ludwig von Mises suggested otherwise, concluding that the fundamental driving force of interest rate determination is not the central bank at all, but an individual’s time preferences.

What are time preferences? As a rule, people assign a higher valuation to present goods versus future goods.The degree of this preference for present over future goods is the degree of an individual’s time preference.

The result of this is that present goods are valued at a premium to future goods. It is this valuation that sets natural interest rates[which, as a consequence, are always positive and cannot be negative].

This valuation stems from the fact that a lender or an investor gives up some benefits at present. Hence the essence of the phenomenon of interest is the cost that a lender or an investor endures. On this Mises wrote in Human Action,

That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.

For instance, an individual who has just enough resources to keep himself alive is unlikely to lend or invest his paltry means. The cost of lending, or investing, to him is likely to be very high — it might even cost him his life if he were to consider lending part of his means. So under this condition he is unlikely to lend, or invest even if offered a very high interest rate.

Once his wealth starts to expand however, the cost of lending — or investing — starts to diminish. Allocating some of his wealth toward lending or investment is going to undermine, to a lesser extent, our individual’s life and well being at present. From this we can infer that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate (i.e., the lowering of the premium of present goods versus future goods). Conversely, factors that undermine real wealth expansion lead to a higher rate of “natural” or originary interest.

Time Preference and the Demand for Money

In the money economy, individuals’ time preferences are realized through the supply and the demand for money. The lowering of time preferences (i.e., lowering the premium of present goods versus future goods) on account of real wealth expansion, will become manifest in a greater eagerness to lend and invest money and thus lowering of the demand for money.

This means that for a given stock of money, there will be now a monetary surplus.

To get rid of this monetary surplus people start buying various assets and in the process raise asset prices and lower their yields. Hence, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure

The converse will take place with a fall in real wealth. People will be less eager to lend and invest, thus raising their demand for money relative to the previous situation. This, for a given money supply, reduces monetary liquidity — a decline in monetary surplus. Consequently, this lowers the demand for assets and thus lowers their prices and raises their yields.

What will happen to natural interest rates as a result of an increase in the money supply? An increase in the supply of money means that those individuals whose money stock has increased are now much wealthier, or feel so.

Hence this sets in motion a greater willingness to invest and lend money. The increase in lending and investment means the lowering of the demand for money by the lender and by the investor. Consequently, an increase in the supply of money coupled with a fall in the demand for money leads to a monetary surplus, which in turn bids the prices of assets higher and lowers their yields.

As time goes by the rise in price inflation on account of the increase in the money supply starts to undermine the well being of individuals and this leads to a general rise in time preferences. This lowers an individuals’ tendency for investments and lending, i.e., raises the demand for money and works to lower the monetary surplus — this puts an upward pressure on interest rates.

Monetary Policy and Real Wealth

In a market economy within the framework of a central bank, the key factor that undermines the pace of real wealth expansion is the monetary policy of the central bank.

imageIt is loose monetary policy that undermines the stock of real wealth and the purchasing power of money. We can thus conclude that a general increase in price inflation — resulting from an increase in the money supply and a consequent fall in real wealth — is a factor that sets in motion a general rise in interest rates. Meanwhile, a general fall in price inflation — in response to a fall in the money supply and a rise in real wealth — sets in motion a general fall in interest rates.

Furthermore, an increase in the growth momentum of the money supply sets in motion a temporary fall in interest rates, while a fall in the growth momentum of the money supply sets in motion a temporary increase in interest rates.

The Invisible Natural Rate of Interest

The main problem here is that the natural interest rate can't be observed. How can one tell whether the market interest rate is above or below the natural rate?

Swedish economist Knut Wicksell suggested that policy-makers pay close attention to changes in the price level. Thus a rising price level would call for an upward adjustment in the money rate, while a falling price level would signal that the money interest rate must be lowered. He wrote,

This does not mean that the banks ought actually to ascertain the natural rate before fixing their own rates of interest. That would, of course, be impracticable, and would also be quite unnecessary. For the current level of commodity prices provides a reliable test of the agreement of diversion of the two rates.
    The procedure should rather be simply as follows: So long as prices remain unaltered the banks' rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered; and the rate of interest is henceforth to be maintained at its new level until a further movement of prices calls for a further change in one direction or the other. The more promptly these changes are undertaken the smaller is the possibility of considerable fluctuations of the general level of prices; and the smaller and less frequent will have to be the changes in the rate of interest…..In my opinion, the main cause of the instability of prices resides in the inability or failure of the banks to follow this rule.

In short, banks should adjust the money market interest rate in the same direction as movements in the price level. Note that this procedure is followed today by all central banks. Thus in response to rises in price indexes above an accepted figure the Fed (or the Reserve Bank) raises the federal funds rate target (or the OCR). Conversely, when price indexes are growing at a pace considered as too low the Fed lowers the target.

Despite the fact that the natural interest rate cannot be observed, modern economists are of the view that it can be estimated by various indirect means. For instance one can establish what it is simply by averaging the value of the real fed funds rate (fed funds rate minus price inflation) over a long period of time.

Some other economists hold that the natural rate fluctuates over time and reject the notion that the natural rate can be approximated by an average figure. In order to extract the unobservable moving natural interest rate economists now employ sophisticated mathematical methods such as the Kalman filter.

According to this method a researcher partially adjusts the estimate of the natural rate based on how far off the model's prediction of GDP is from actual GDP. If the prediction coincides with the actual GDP then the assumption regarding the natural rate is kept unchanged. If actual GDP is higher than that predicted by the model then it is assumed that this must mean that monetary policy was more stimulative than expected by the researcher, meaning that the assumption about the natural rate is too low. The estimate of the natural rate goes up by an amount proportional to the GDP prediction error. The assumed natural rate is lowered if actual GDP is lower than the prediction of the model.[12]

But does all of this make much sense?

Are interest rates in financial markets and the real economy distinct phenomena?

The essence of the phenomenon of interest is the cost that the saver of saved money endures. This cost stems from the fact that the saver has given up some benefits at present. On this Mises wrote,

That which is abandoned is called the price paid for the attainment of the end sought. The value of the price paid is called cost. Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at.

The fact that the saved dollar incurs a cost to the saver means that the same dollar that is employed to secure goods at present carries a premium over the saved dollar, which will be employed by the saver to secure goods only in the future. According to Carl Menger:

To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well being in a later period……..All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.

Likewise, according to Mises,

Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.15

Hence an individual will undertake the act of saving only if the return on the saved dollar will be in excess of the cost of saving. We are back again to time preference where, according to Mises,

The postponement of an act of consumption means that the individual prefers the satisfaction which later consumption will provide to the satisfaction which immediate consumption could provide.

By assigning a higher valuation to the present dollar versus the future dollar on account of the cost incurred by the act of saving an individual therefore expresses a positive time preference.

imageWould it be possible in a world without money, such as suggested by Wicksell, to establish the rate of return on present goods in terms of future goods? In a world without money all that one would have are the rates of exchanges between various present and future real goods. For instance, one present apple is exchanged for two potatoes in a one-year's time. Or, one shirt is exchanged for three tomatoes in a one-year's time. Again all that we have here are various ratios.

There is, however, no way to establish from these ratios what the rate of return is for one present apple in terms of future potatoes (It is not possible to calculate the percentage since potatoes and apples are not the same goods). Likewise we cannot establish the rate of return on a shirt in terms of future tomatoes. In other words, we can only establish that one present apple is exchanged for two future potatoes, and one present shirt is exchanged for three future tomatoes. Only in the framework of the existence of money can the rate of return be established.

For instance, the time preference of a baker, which is established in accordance with his particular set-up, determines that he will be ready to lend ten dollars - which he has earned by selling ten loaves of bread - for a borrowers promise to repay eleven dollars in a one year's time. Similarly the time preference of a shoemaker, which is formed in accordance with his particular set-up, determines that he will be a willing borrower. In short, once the deal is accomplished both parties to this deal have benefited. The baker will get eleven dollars in one-year's time that he values much more than his present ten dollars. For the shoemaker the value of the present ten dollars exceeds the value of eleven dollars in one-year time.

As one can see here, both money and the real factor (time preferences) are involved in establishing the market interest rate, which is 10%. Note that the baker has exchanged ten loaves of bread for money first (i.e., ten dollars). He then lends the ten-dollars for eleven dollars in one-year's time. The interest rate that he secures for himself is 10%. In one-year's time the baker can decide what goods to purchase with the obtained eleven dollars. As far as the shoemaker is concerned he must generate enough shoes in order to enable him to secure at least eleven dollars to repay the loan to the baker.

Observe however, that without the existence of money – the medium of exchange – the baker isn't able to establish how much of future goods he must be paid for his ten loaves of bread that would comply with the rate of return of 10%.

So if the rate of return cannot be established in the real economy apart from money it also cannot be established in the world of money apart of real goods. It will be absurd to lend money without any connection to the real world - after all the role of money is to facilitate the exchange of real goods and services.

Consequently, there cannot be any separation between the real and financial market interest rates. There is only one interest rate, which is set by the interaction between individuals' time preferences and the supply and demand for money. Since the influences of demand and supply for money and individuals' time preferences regarding interest rate formation are intertwined, there are no ways or means to isolate these influences. Hence, the commonly accepted practice of calculating the so-called real interest rate by subtracting percentage changes in the consumer price index from the market interest rate is erroneous. So if the real interest rate cannot be ascertained it follows that the natural interest rate cannot be established either.

imageAdditionally, recall that according to Wicksell the natural rate is defined as the rate at which the demand for physical capital coincides with the supply of real savings. However, the total physical demand and supply of capital cannot be established since capital goods are heterogeneous and cannot be added up to a total.

We can thus conclude that economists' and central bankers' attempts to establish the natural interest rate must therefore be regarded as an impossible mission.

Furthermore, the fact that the driving force of interest rate determination is individuals time preferences means that the causality emanates from individuals and not some other outside factor. For instance, mainstream economists generally accept that an increase in inflationary expectations automatically pushes interest rates up.

It is true that a change in inflationary expectations is likely to be reflected in higher interest rates. However, there is no automatism here since it is individuals that assess the nature of inflationary expectations and adjust their time preferences in accordance with their own circumstances. Likewise an increase in uncertainty will not automatically raise interest rates without individuals' assessments first. In short, it is individuals' assessments regarding various events that alter their time preferences and in turn the market interest rate.

The central bank and interest rates

According to the Wicksellian framework in order to maintain price and economic stability, once the gap between the financial market interest rate and the natural rate is closed the central bank must at all times ensure by means of a suitable monetary policy that the gap does not emerge. In other words, in the Wicksellian framework a monetary policy that maintains the equality between the two rates becomes a factor of stability. But is this possible? After all, maintaining this equality means that the central bank would have to manipulate the supply of money, which in turn will make things unstable.

For instance, whenever the central bank loosens its monetary stance the injection of new money into the economy benefits individuals who receive the newly created money first, and at the expense of those individuals who don't receive the new money at all, or who receive it late. The early recipients can now purchase a greater amount of goods while the prices of these goods are still unaffected. In other words, the early recipients' real wealth has increased. According to Rothbard,

The individuals who receive the new money first are the greatest gainers from the increased money; those who receive it last are the greatest losers.

The increase in wealth also means that the early recipients of money can now undertake various projects that before the increase in money they couldn't afford - implying that, all other things being equal their time preferences will decline.

A person with a very meagre money income can only afford means that will enable him to just sustain his physical survival. For him to undertake savings would entail a very high cost hence his time preference will be very high. However, as his purchasing power rises he can now undertake various ventures that he previously couldn't afford, which will generate benefits some time in the future. In other words, with a rise in purchasing power his time preference tends to decline i.e. he is likely to increase his savings. Consequently, this will reinforce the lowering of the interest rate in the money market by the central bank.

imageIn other words, a fall in the time preferences of the early recipients of money provides the support for the act of lowering of interest rates by the central bank. Without this fall in time preferences the central bank's plan of lowering of interest rates in the economy couldn't be implemented. After all as we have seen financial markets without the real stuff don't have a life of their own.

Furthermore, because the early recipients of money are much wealthier now compared to before the monetary injections took place, they are likely to alter their patterns of consumption. With greater wealth at their disposal, their demand for less essential goods and services expands. The increase in the real wealth of the first recipients of money gives rise to the demand for goods which, prior to monetary expansion, would not have been considered.

A change in the pattern of consumption draws the attention of entrepreneurs who, in order to secure profits, start to adjust their structure of production in accordance with this new development. Now, on account of loose money policy entrepreneurs' find it easy to secure new loans from the banking system - an economic boom ensues.

Once however, the newly-pumped money by the central bank and commercial banks starts to spread across the economy it pushes up the prices of goods and services, which undermines the purchasing power of the last recipients of money, or those who weren't recipients at all. This is likely to lift their time preferences, which in turn puts upward pressure on interest rates. In order then to sustain the lower interest rate structure the central bank must inject another dosage of new money.

Note that the act of lowering of the interest rate by the central bank leads to the diversion of real wealth from last recipients of money to the early recipients. In the process this gives rise to the various structures of production that a free market economy would not support. Again, the key to this diversion is monetary pumping, which is followed by a lowering of interest rates. There is however, a limit to all this, which is set by the pool of real funding, or the subsistence fund.

As long as this pool is growing the central bank can get away with loose monetary policies for a long period of time. However, once the pool begins to shrink a sharp fall in economic activity ensues. This leads to the accumulation of bad debts by banks and to the subsequent curtailment of bank lending. As a result the money that sprang-up on the back of fractional reserve lending tends to evaporate.

Consequently, the fall in the supply of money sets in motion tendencies for a rise in interest rates. Note that the increase in interest rates is supported here by the rise in individuals' time preferences on account of a fall in the pool of real funding. Also note that the fall in the pool has set the platform for the disappearance of money created through fractional reserve banking. The fall in the pool of real funding raises individuals' time preferences and also sets in motion a decline in the stock of money. As a rule however, central banks tend to arrest the boom before it becomes excessive by lifting the money market interest rate once price inflation begins to rise.

imageWe can thus conclude that even if the Fed could know the level of the natural rate, it could not achieve economic stability. The reason is that the Fed would have to pursue active monetary policies in order to maintain the natural rate target. This very act, however, leads to boom-bust cycles and economic instability. Hence there cannot be such a thing as a ‘neutral' interest rate policy.

Rather than targeting the money market interest rate towards the unknown natural rate by means of monetary tampering, which leads to more instability, a better alternative is to leave the economy alone. In a free market economy without a central bank no one would be conducting any kind of monetary policies. In the absence of central bank monetary policies, which enrich some individuals at the expense of other individuals, the interest rates that emerge will be truly neutral. In a free market then, no one would be required to establish whether the interest rate is above or below some kind imaginary equilibrium. Furthermore, in a free market with the absence of money printing there cannot be the issue of a general rise in prices that must be countered.


Our examination of the framework of thinking that the Fed's decision makers use reveals that policies pursued by the US central bank will only promote more instability rather than achieving a balanced economy. The essence of the Fed's thinking emanates from writings of Knut Wicksell, who suggested that the key to economic stability is targeting the financial market interest rate at the natural interest rate.

Our analysis however, has shown that it is not possible to isolate the so-called natural rate. Consequently, policies that are aimed at an unknown interest rate target run the risk of promoting more rather than less instability. Also, even if one was to know what the natural rate was, the act of reaching and maintaining this target by means of monetary policies will destabilise the economy.

Any attempt therefore by means of policies to bring the market interest rate towards the natural rate and keep it there cannot be neutral with regard to the economy. A better way to reach healthy economic conditions is by leaving the economy free of any tampering by the central authorities. We have estimated that based on the past money supply rate of growth the growth momentum of economic activity as measured by personal income at current prices is likely to weaken from the second half of this year.

Image result for Frank ShostakDr Frank Shostak is the head of Australian research firm Applied Austrian Economics Ltd, and one of the world leaders in the applied Austrian School of Economics. An adjunct scholar at the Mises Institute in the US, Dr Shostak has been an economist and market strategist for MF Global Australia (previously Ord Minnett) since 1986. During 1974 to 1980 he was head of the econometric department at the Standard Bank in Johannesburg South Africa. During 1981 to 1985 he was head of an economic consulting firm Econometrix in Johannesburg.

This post first appeared as two separate posts at the Mises Daily.

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University of Auckland Economics Group

Seminar: Is Inflation Targeting a Sensible Way to Conduct Monetary Policy?

Dr. Don Brash, ex-Governor of the Reserve Bank of New Zealand

The University of Auckland Economics Group is proud to host Dr. Don Brash. As the Governor of the Reserve Bank of New Zealand for 14 years, Dr. Brash had a major influence on the way that monetary policy is now conducted, not only in New Zealand but also globally.

Please register your attendance at:


In this week’s seminar, Dr. Brash will reflect on some of these landmark changes he implemented as Governor of the RBNZ and offer some thoughts on how monetary policy is conducted today. In particular, he will offer some insight into the following questions:

Is inflation targeting a sensible way of conducting monetary policy?

How did New Zealand lead the world in developing an inflation targeting policy?

How does the single policy objective of targeting the inflation rate compare with the “dual mandate” of the Federal Reserve in the United States?

Do wider policy objectives as macro-prudential policy impact on the Reserve Bank of New Zealand’s ability to effectively target inflation?

And, crucially, what role does central bank independence play in all of this?

      Date: Thursday, October 1
      Time: 6-7pm
      Location: University of Auckland Business School. Room TBC.

Speaker Bio:

The New Zealand Association of Economists, of which Dr. Don Brash is a distinguished fellow, states that: ‘There can only be the barest handful of New Zealand economists who have had a career that is both as distinguished and varied as that of Don Brash.’ In his 14 years as the Governor of the Reserve Bank of New Zealand, Don famously pioneered a set of major reforms, reforms which would ultimately impact on how monetary policy is conducted globally. These included creating a new approach to central bank independence and guiding the RBNZ to become the first central bank in the world to formally adopt inflation targeting.


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