Interest rates and debt were discussed in the latest print edition of The Economist. Specifically, the author suggests that “interest rates are too low” and seeks to find the answer to this quagmire.
Unsurprisingly, the author postulates that the theory which best explains the current phenomenon comes from the Austrian School:
The problem is that most central banks base their policy analysis on Keynesian-style economic models in which deviations from their inflation goal are assumed to reflect excess or inadequate demand, requiring a change in monetary policy. But supply shocks such as globalisation can cause deviations in inflation that require a completely different policy response. A more relevant model might be one based on the Austrian school of economics, developed in the late 19th century, when economic conditions were more akin to today’s. In Austrian models the main result of excessively low interest rates is not inflation but overborrowing, an imbalance between saving and investment and a consequent misallocation of resources. That sounds like America today.
More on ABCT: 1 2 3 See also The Theory of Money and Credit.
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Related question on this issue: in terms of the interest rates I can currently get on savings, and borrowing, does any of it really have anything to do with market forces? Doesn’t the Fed just manipulate the money supply so as to get whatever nominal interest rates it feels like? Do interest rates as they stand now really signal useful information about market actors, as opposed to being purely what the Fed wants it to be?
Person: The Fed controls only short-term interest rates. Long-term rates are based on bond prices. So when the Fed tightens short-term rates, long-term rates do not necessarily go up as well. In fact if malinvestment projects are being canceled, they should go down, creating the inverted yield curve.
In passing, isn’t it ironic how empiricists are discovering that Austrian theory makes better empirical predictions than their own models?
Urban: but aren’t the bond prices themselves, ultimately formed by Fed monetary policy?
Person,
They are influenced by it, but not dominated by it. the ultimate determinent of bond rates is what yields people are demanding of them to be willing to pay the asking price. The policy of the Fed is just one of many variables going into the calculations of those who buy the long term bonds.
The Fed doesn’t set interest rates. It can not set anything besides the discount rate and try to hit its fed funds rate. It does obviously influence them by its policies, though, such as prime usually being the fed funds rate + 3 points(but even here, lots of consumer loans are at prime plus).
The fed sets a “target rate”. Simple supply and demand for capital (capital measured in dollars). Demand is people wanting to borrow or sell stock and supply is people’s savings. At least it is suppose to be this way. The Fed simply increases supply by “printing money” and buys short term debt from the government. Price goes up (increase demand from Fed) and interest rates go down on short term paper.
http://www.ny.frb.org/markets/openmarket.html
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