After closing at 3.03 percent in December 2013, the yield
on the 10-year US T-Note has been trending down, closing at 2.34 percent by
August this year. Many commentators are puzzled by this, given the optimistic
forecasts for economic activity by Fed policy makers.
According to mainstream thinking, the central bank is the
key factor in determining interest rates. 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.
Following the expectations theory (ET), which is popular
with most mainstream economists, the long-term rate is an average of the
current and expected short-term interest rates. If today’s one-year rate is 4
percent and next year’s one-year rate is expected to be 5 percent, the
two-year rate today should be (4 percent + 5 percent)/2 = 4.5 percent.
Note that interest rate in this way of thinking is set by
the central bank whilst individuals in all this have almost nothing to do 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.)
Based on the ET and following the optimistic view of
Fed’s policy makers on the economy, some commentators hold that the market is
wrong and long-term rates should actually follow an up-trend and not a
down-trend.
According to a study by researchers at the Federal Reserve Bank of San
Francisco (Assessing Expectations of Monetary
Policy, September 8, 2014) market players are wrongly interpreting the
intentions of Fed policy makers. Market players have been underestimating the
likelihood of the Fed tightening its interest rate stance much sooner than is
commonly accepted given Fed officials’ optimistic view on economic activity.
It is held that a disconnect between public expectations
and the expectations of central bank policy makers presents a challenge for
Fed monetary policy as far as the prevention of disruptive side effects on
the economy is concerned, on account of a future tightening in the interest
rate stance of the Fed.
We suggest that what matters for the determination of
interest rates are individuals’ time preferences, which are manifested
through the interaction of the supply and the demand for money, and not
expectations regarding short-term interest rates. Here is why.
The Essence of Determining Interest Rates
Following the writings of Carl Menger and Ludwig von
Mises, we suggest that the driving force of interest rate determination are
individuals’ time preferences and not the central bank.
As a rule, people assign a higher valuation to present
goods versus future goods. This means that present goods are valued at a
premium to future goods.
This 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,
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.[1]
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.[2]
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.[3]
Hence, 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.[4]
For instance, an individual who has just enough resources
to keep him 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, 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 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 interest.
Time Preference and Supply 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 lower 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,
all other things being equal.
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 (i.e., a decline in monetary surplus). Consequently, all other
things being equal, this lowers the demand for assets and thus lowers their prices
and raises their yields.
What will happen to interest rates as a result of an
increase in money supply? An increase in the supply of money, all other
things being equal, means that those individuals whose money stock has
increased are now much wealthier.
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.
But, as time goes by, the rise in price inflation on
account of the increase in money supply starts to undermine the well being of
individuals and this leads to a general rise in time preferences.
This lowers 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.
We can thus conclude that a general increase in price
inflation on account of an increase in money supply and a consequent fall in
real wealth is a factor that sets in motion a general rise in interest rates
whilst a general fall in price inflation in response to a fall in money
supply and a rise in real wealth sets in motion a general fall in interest
rates.
Explaining the Fall in Long-Term Interest Rates
We suggest that an uptrend in the yearly rate of growth
of our monetary measure AMS since October 2013 was instrumental in the
increase in the monetary surplus. The yearly rate of growth of AMS jumped
from 5.9 percent in October 2013 to 10.6 percent by March and 10.3 percent by
June this year before closing at 7.6 percent in July.
Furthermore, the average of the yearly rate of growth of
the consumer price index (CPI) since the end of 2013 to July this year has
been following a sideways trend and stood at 1.6 percent, which means a
neutral effect on long-term yields from the price inflation perspective.
Also, the average of the yearly rate of growth of real GDP, which stood at
2.2 percent since 2013, has been following a sideways movement: a neutral
effect on long term rates from this perspective.
Hence we can conclude that the rising trend in the
growth momentum of money supply since October last year was instrumental in
the current decline in long-term rates.
Conclusion
Since December 2013 the yields on long-term US Treasuries
have been trending down. Many commentators are puzzled by this given the
optimistic forecasts for economic activity by Fed policy makers.
Consequently, some experts have suggested that market players have been
underestimating the likelihood of the Fed tightening its interest rate stance
much sooner than is commonly accepted. We hold that regardless of
expectations what ultimately matters for the long-term interest rate
determination are individuals’ time preferences, which is manifested through
the interaction of the supply and the demand for money. We suggest that an
up-trend in the yearly rate of growth of our monetary measure AMS since
October 2013 has been instrumental in the increase in the monetary surplus.
This in turn was the key factor in setting the decline in the trend in
long-term interest rates.
