The Fed's Power Over Inflation And Interest Rates Has Been Greatly Exaggerated

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It is widely held that the central bank is a key factor in the determination of interest rates. By popular thinking, the Fed influences the short-term interest rates by influencing monetary liquidity in the markets. Through the injection of liquidity, the Fed pushes short-term interest rates lower. Conversely, by withdrawing liquidity, the Fed exerts an upward pressure on the short-term interest rates.

Popular thinking also suggests that long-term rates are the average of current and expected short-term interest rates. If today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 5 percent, then the two-year rate today should be 4.5 percent ((4 + 5)/2 = 4.5%). Conversely, if today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 3%, then the two-year rate today should be 3.5 percent (4 + 3)/2 = 3.5%.

Hence, it would appear that the central bank is the key in the interest rate determination process. However, is this the case? 

Individuals’ Time Preferences and Interest Rates 

It is individuals’ time preferences rather than the central bank that hold the key in the interest rate determination process.

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 to consider lending part of his means. Therefore, he is unlikely to lend or invest, even if offered a very high-interest rate. Once his wealth starts to expand, 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, all other things being equal, that anything that leads to an expansion in the wealth of individuals is likely to result in the lowering of the premium of present goods versus future goods. This means that individuals are likely to accept lower interest rates.

Note that interest is the outcome of the fact that individuals assign a greater importance to goods and services in the present against identical goods and services in the future. The higher valuation is not the result of capricious behavior, but of the fact that life in the future is not possible without sustaining it first in the present. 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.1

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