Reply To: Artficially low interest rates


Interest rates are not determined by supply conditions alone, but by demand and supply. Demand for credit has collapsed in the wake of the over-indebtedness of the boom. Both consumers and entrepreneurs are paying down debt.

(As an aside, the same analysis applies to price inflation. The purchasing power of money is determined by both the demand to hold money and the money stock, not the money stock alone. Thus, even though the money stock has been increasing, there has been little price inflation because people’s demand to hold money has increased, as it typically does in a downturn.)

Furthermore, “money printing” by the central bank does not mechanistically expand the supply of credit. The Fed has purchased around $1 trillion of assets from banks and paid with newly issued base money. But, banks must decide to issue fiduciary media on top of theses reserves to expand credit. They haven’t been doing this. Instead, they are holding the additional base money created by the Fed as excess reserves to shore up their balance sheets.

In normal times, the Fed influences market interest rates by stimulating banks to produce credit expansion. Lowering the discount rate can be a technique to do this, but the main method it uses is buying assets from banks. With the larger reserves, the banks then expand the supply of credit by issuing fiduciary media. The increased supply of credit lowers interest rates.

Interest rates will rise to normal levels when the demand side of the time market returns to normal. Normalcy will return when the pay down of debt is complete and the conditions for investment improve.