Does the Central Bank Determine Interest Rates?

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Frank Shostak
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Most experts agree that, through the manipulation of the short-term interest rates, the central bank can also determine the direction of the long-term interest rates. Some popular thinking alleges that the long-term interest rates are the average of the present and the expected short-term interest rates. Hence, it would appear that the central bank is the key in determining the interest rates. But is this valid?

Individual time preferences and interest rates

According to thinkers such as Carl Menger and Ludwig von Mises, interest is the outcome of the fact that individuals assign a premium to present goods against identical goods in the future (i.e., time preference). The preference is not the result of capricious behavior but because life in the future is not possible without sustaining it first in the present. On this Carl Menger suggested,

Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economizing men generally endeavor to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.

Various goods required to sustain man’s life at present must be of a greater importance to him than the same goods in the future. Likewise, according to Mises,

He who wants to live to see the later day, must first of all care for the preservation of his life in the intermediate period. Survival and appeasement of vital needs are thus requirements for the satisfaction of any wants in the remoter future.

The restriction of consumption is saving and the transfer of labor and land toward capital formation is investment. Saved consumer goods sustain individuals that are employed in the making of tools and machinery (i.e., capital goods). The expansion of saving lowers the premium of the present consumption versus the future consumption (i.e., stably lowers the interest rate). Conversely, factors that undermine saving increase the premium of the present consumption versus the future consumption (i.e., increases the interest rate). Furthermore, increases in saving lowers the individual time preferences whereas decreases saving increase time preferences.

Life sustenance and zero interest rate 

As a rule, with the expansion of savings, individuals tend to allocate more towards the accomplishment of remote goals in order to improve their quality of life over time. With scarce goods and little saving, an individual can only consider very short-term goals, such as making a simple tool. The meager savings does not permit him to undertake the making of more advanced tools (i.e., capital goods). With an increase in saved goods, he could consider undertaking the construction of better tools.

No individual undertakes a goal which promises nothing in return. The maintenance of the process of life over and above hand-to-mouth existence requires an expansion of savings and production. This expansion implies positive returns. It is through the expansion of savings—after allowing for the maintenance of life in the present—that greater production and investment become possible. These savings, in turn, permit a further expansion of the same process—a greater allocation of savings towards longer-term goals, implying a greater preference for greater future consumer goods, and a consequent lowering of interest rates. The extra savings that become available are invested because the expected future benefits outweigh the benefits of consuming these savings in the present. 

Interest rates guide businesses 

Since interest is established in monetary terms, the money supply is a determining factor of the interest market interest rate. Interest, however, is the outcome of a higher valuation of present goods versus future goods. Being the medium of exchange, money only facilitates loan exchanges through time. Changes in interest rates inform entrepreneurs about the feasibility of undertaking various capital projects. A fall in the interest rates implies that a greater proportion of savings has been made available for these projects. Conversely, an increase in the interest rates implies a lower amount of savings can be allocated to these projects. 

By setting the interest rate through exchanges through time, both a borrower and a lender of savings allow for the fluctuations in the purchasing power of money. Expectations for the decline in the purchasing power of money is likely to contribute to an increase in the interest rate expressed in monetary terms. Conversely, expectations that money’s purchasing power is going to increase is likely to contribute towards the lowering of interest rates. 

An artificial increase in money supply (all other things being equal), erodes the purchasing power of money, and also weakens the flow of savings by setting an exchange of nothing for something. This weakens the formation of saving and capital investment which, in turn, increases preferences toward present consumption. Hence, an increase or decrease in interest rates correspond to individual time preferences. Conversely, a decline in the money supply strengthens saving, lowers individual time preferences (i.e., the lowering of interest rates), and allows for capital formation.

Does the lowering of interest permit a greater capital formation?

The artificial lowering of interest rates through inflation does not increase capital investment. It is true that businessmen react to changes in the interest rates. What permits stable expansion of capital goods is not the lowering of the interest rates via inflationary expansion of money and credit, but an increase in the pool of savings. In that case, a greater allocation of savings contributes toward the buildup of the infrastructure (i.e., capital goods). This is manifested by the lowering of people’s time preferences. Therefore, it is saving and capital investment, not the lowering of the interest rate as such, that allows for such growth. 

When not tampered with, the monetary interest rate serves as an indicator to businesses regarding the availability of savings enabling the possible build-up of a wealth-generating structure of production. On the other hand, whenever the central bank artificially tampers with the interest rate through inflationary monetary policy, it falsifies this indicator. This thereby breaks the harmony between the production of present consumer goods and the production of capital goods. A malinvestment boom emerges. The over-investment in certain capital goods at the wrong time results in an artificial boom; the liquidation of this malinvestment produces a bust. Hence, the boom-bust economic cycle. On this, Rothbard wrote,

…once the consumers reestablish their desired consumption/investment proportions, it is thus revealed that business had invested too much in capital goods (hence the term “monetary overinvestment theory”), and had also underinvested in consumer goods. Business had been seduced by the government tampering and artificial lowering of the rate of interest, and acted as if more savings were available to invest than were really there.

Conclusions 

As long as basic life-sustenance remains the ultimate goal of individuals, they are going to assign a higher valuation to present goods versus future goods. Any attempt by central bank policymakers to overrule this is going to undermine the individuals’ living standards.