[rt]

Hi,
Interest rates remain extremely low in the US, Europe and Japan and if they rose, the financial sector and governments would be in big trouble. (Bonds would lose value, debt would accumulate faster). My question is: Are interest rates so low because of increases in the money supply of various currencies (€, ¥, $) or because Central Banks have lowered the discount rate? Which factor is more important? Can a CB lower interest rates in the market only by lowering its discount rate or is money “printing” necessary as well?
My second question is wether interest rates can remaon so low for a long period of time. Don’t they have to rise at some point? When do you think they’ll rise?
Thank you!

[jmherbener]

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.

[ronigafni]

What about the affect of their manipulation of the federal funds rate? Does that also lower interest rates?

[jmherbener]

The federal funds rate is the interest rate for inter-bank, overnight lending. Banks lend to other banks overnight mainly to provide reserves to the borrowing banks. So, the Fed manipulates the Federal Funds rate by purchasing assets from banks and thereby, increasing bank reserves. With a greater total stock of reserves, the Federal funds rate will be lower, given the total demand for reserves. The Fed adjusts its buying of assets to generate the amount of reserves to hit its target rate for the Federal Funds interest rate, currently 0-0.25 percent.

When banks have more reserves, they can create more credit by issuing fiduciary media. The additional supply of credit will lower interest rates. (Currently, banks are holding excess reserves instead of creating more credit.)

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