Why should central banks cut interest rates?

Central banks around the world are whacking interest rates at a breakneck clip. The Fed, the Reserve Bank of Australia, the Bank of Japan and now the ECB and the BoE. The BoE made the most dramatic move with an outsized 150 basis point cut. However, I am not convinced this is what the market needs.

Why are central banks cutting interest rates?

The conventional wisdom is that cutting interest rates provides monetary stimulus. Cutting interest rates will help prop up the economy at a time when commodity prices are plummeting, making inflation less of a concern. I do believe this is true and some easing might be just what we need at this delicate point. However, I also believe cutting rates has unintended consequences — and one of them is increasing the appetite for risk.

Before I go into why this is so, let me explain how I see interest rates with a blurb from a previous post.

The purpose of interest rates

Consider money to be just like any other good. Therefore, a loan is essentially an exchange of a ‘present good’ (money that can be used today) for a ‘future good’ (an IOU -money that can be used later). Because people will always prefer having a good straight away than receiving that good later, the present good commands a premium in the marketplace. That premium is the rate of interest.

Interest rates, therefore, represent the time value of money. It is the mechanism through which individuals express ‘time-preferences’ i.e., how much more they value receiving money right now as opposed to a later date. The premium of present money over future money fluctuates according to people’s time preferences; if people want money today very badly, the premium for money today (interest rate) will be high.

So, the purpose of credit and interest rates is clear. It is the mechanism by which one is compensated for deferring consumption today for later consumption.

The business cycle

Loans on credit also create the boom-bust business cycle. In our fractional reserve deposit banking system, banks must keep on hand only a portion of the money we deposit. The rest is lent out as credit. Therefore, if all depositors were to rush to the bank to redeem their deposits, the bank would not have enough cash on hand and would be declared insolvent. This is what happens in a bank run. To avoid a run, banks must maintain the confidence of depositors by acting prudently and cautiously in extending credit. If not, they risk insolvency.

The problem is that human nature steps in; as the business cycle progresses, the banks lend more and more money. Naturally, some of those loans are ‘bad’ loans i.e., the debtor cannot pay back the full principal at the required time. The banks must account for these bad loans in their loan loss reserves.

However, at some point, when the credit cycle has progressed too far, one of two things occurs:

  • The economy ‘overheats’ and inflation starts to rise. Whispers start circulating that the central bank will raise interest rates and that inflation is spiraling out of control. The central bank does increase interest rates and many loans that looked good in a lower interest rate environment start to go sour.
  • Banks simply start lending to too many questionable debtors and more loans go bad than anticipated.

As rumors circulate that this bank or that bank has been lending imprudently, the banks dig in their heels and pull back. Interest rates go up, credit contracts, and the economy goes into recession.

This is the business cycle. It is a natural part of our capitalist system and it is entirely created by the extension of credit.

In my view, cutting interest rates below their natural level distorts time preferences and investment decisions, causing individuals and companies to take on more risk — risk that they will later regret having taken. In effect, the central bank is goading people into misconstruing the riskiness of the decisions they are making by keeping interest rates artificially low.

A perfect example is the previous housing bubble. If interest rates should be 5% but they are 1%, then home builders are going to increase their indebtedness to take on more projects with longer and longer completion time frames. A project that comes online 5 years out looks much less risky when you can borrow money for 4 or 5% less.

Another example of this right now comes in the form of levered ETFs. These are exchange traded funds that allow investors speculators the opportunity to double or triple the gains from investing in the stock market. See Paul Kedrosky’s take on this here.

While gains are levered, so are losses and it seems amazing to me that investors are taking on that much risk after the drubbing we all took in October. But, when interest rates are cut to 1%, that is what happens.

Why don’t central banks leave interest rates alone but lend freely against good collateral? Intervene in the commercial paper market if you must, but stop distorting investment decisions. The only reason that rate are being cut so low is political pressure, plain and simple.

And when politics drives economic and monetary policy, bad things happen.

Source post
The ECB is right and the Fed is wrong

16 Comments
  1. hbl says

    I agree with your points.

    However, another common argument as to why central bankers see low rates as beneficial now is that in theory low rates can reduce current debt servicing burdens for adjustable rate debt (ARMs, credit cards, etc). Obviously this is meeting with mixed success and must be weighed against the drawbacks you mention.

  2. Edward Harrison says

    good to hear from you. I know what you mean about the ARM rates. This is exactly the dilemma that Greenspan had as he raised rates. Interest rate policy is a blunt instrument and it doesn’t necessarily have the intended consequences.

    I have sympathy for Bernanke. If I were Bernanke, I would be hard pressed to make the right choices as well. No one wants to preside over a depressionary downward spiral yet the risks on the other side are equally daunting – inflation, dollar crash, more bubbles, etc.

    Ultimately, it all reinforces the notion that it may well be best to set interest rates at an appropriate level and let the Government worry about stimulus.

  3. Anonymous says

    Banks do not lend their deposits as loans.On the contrary,the latter are created as money “today” out of “future” money and the banks are only limited in creating that money by the cash reserve ratio.Proceeds of loan money go towards enhancing the deposits in the entire banking system.When loans are repaid from incoming(future)revenue both loans(banks’assets) and deposits(banks’ liabilities)are decreased simultaneously.That is why many economists talk about creating money “out of thin air”.

  4. Edward Harrison says

    anonymous,

    I don’t follow you. Would you mind being more thorough in explaining your case. In regards to “out of thin air,” that usually applies to the central bank creating money out of thin air i.e. buying treasuries with previously non-existent money. How is it that banks are creating money out of thin air?

  5. Edward Harrison says

    anonymous,

    this Wikipedia entry might be the best way to bridge the gap in what we are saying:

    http://en.wikipedia.org/wiki/Money_creation

    What I am saying is that Central Banks can create money by buying assets with non-existent dollars that they actually create out of thin air. On the other hand, commercial banks create credit by loaning out money.

    The money multiplier allows the credit creation. Perhaps this is what you refer to when you refer to banks creating money. But, I see this credit not as money but credit.

  6. gepay says

    generally this is a semantic argument with my opinion being both are correct. In the US only the Fed creates Federal Reserve Notes that everybody calls dollars. To most people the credit that banks create, are also dollars. They can spend now but have to pay them back later. The difference is the dollars created by the FED don’t disappear like the credit created by the bank when the loan is repaid. (Is that true? What if the US paid back all if its debt? [not that we need to worry about that]Would the money suppy dissappear? It certainly would be smaller.) But really there is a continuum of moneyness along with the velocity of money. If I spend $10 dollars, on that day I had $10 dollars and someone else had $10 dollars later that day that they could spend on that day, so on that day there was $20 dollars circulating as opposed to only $10 dollars in my wallet if I stayed home and watched a soccer game on TV.
    I have read of a bubble being created in the Kuwaiti stock market simply on the IOUs of the wealthy speculators in the ruling families. It burst of course.
    Liquidity is not real wealth and maybe dollars aren’t either. If Helicopter Ben drops too many of them into the world economy trying to stop the deflation of deleveraging it could be Weimar time or maybe just a new variation on the 70’s that seemed to be happening when oil was high – without wage increases this time.
    Which brings us to the Daily Reckonings paradigm of the war between inflation and deflation. It seems Bernanke became the head of the Fed purposely to counteract deflation. This leads me to believe that the ‘powers that be’ knew Greenspan was creating this debacle. “One bubble may be an accident,” noted a columnist in the Financial Times, “but two in the space of a decade begins to look like carelessness.”
    Or design if you ask me.

  7. Wag the Dog says

    The difference is the dollars created by the FED don’t disappear like the credit created by the bank when the loan is repaid. (Is that true? What if the US paid back all if its debt?

    I.O.U.S.A. gives some insight to where government debt is heading and what are the possible geo-political implications of having foreigners owning an ever increasing proportion of US debt.

  8. ndk says

    Increasing risk appetite is most certainly not an unintended consequence, is it? That’s the entire point of it, as you explain. The central bank, well aware of the natural tendencies of a capitalistic system to swing back and forth, is trying to compel investors to be less aggressive during good times, and less cautious during bad times. In both cases, it’s against the investors’ will, and intended to be for the collective good.

    Central bankers aren’t stupid, and they’re operating from a base of research and practical experience that we don’t have. Extended time preferences are exactly what we don’t need right now. We needed a lot more of it 4 years ago, and that’s where my beef is.

    We now have pretty good ways to measure real interest rates, and not-great-but-improving ways to estimate natural real interest rates. It was pretty clear through even a basic Taylor Rule analysis that policy was too lax. Greenspan’s famous conundrum indicated they knew something was wrong in the long end of the curve.

    I think our biggest policy error was losing control to the shadow banking system, and petrodollar/Asian recycling flows. Manipulation of time preferences is just fine by me.

  9. ndk says

    Pardon me, decreased time preferences, not extended.

  10. Edward Harrison says

    thanks for the comments on this post. I had a few thoughts to add to the discussion here. ndk said he has no problem with altering time preferences. And I have no problem with that on the margin, but the amount of interest rate manipulation is so large as to be distortionary. It distorts investment decisions. it distorts savings and spending decisions. And it distorts risk management decisions.

    One reason we lost control of the shadow banking system was certainly (lack of) regulation but another reason is that these organizations were incented to take on more risk. They were merely responding to the signals given by monetary policy. And this is true regardless of whether you think about Mortgage lending, high yield debt, leveraged buy outs, hedge funds, credit cards and on and on.

    And gepay says this carelessness may be designed. It may well be. Financial services is a special interest group that is definitely getting what it wants at the expense of everyone else. This has to stop.

  11. I R James says

    “When loans are repaid from incoming(future)revenue both loans(banks’assets) and deposits(banks’ liabilities)are decreased simultaneously.” This is precisely what we are experiencing, a wholesale contraction in the money supply due to businesses and consumers paying down debt and repairing their badly damaged balance sheets. Arguing over monetary policy is a mute point because interest rates have little to no effect when, in the aggregate, the economy is paying down debt faster than it is taking out credit. A perfect example of the irrelevance of monetary policy during this type of “debt rejection” downturn is Japan and its ZIRP throughout the 1990’s.

  12. Edward Harrison says

    I R James,

    I agree that right now the deleveraging renders monetary policy useless. This is why the Fed and others are resorting to quantitative easing aka printing money.

    Ultimately, all of this means that there is an inflationary erosion of the value of money underneath the piles of debt and deleveraging waiting to assert itself. I am not in favor of lowering interest rates to ward of deflation.

  13. I R James says

    Quantitative easing will also have little simulative or inflationary impact in the medium term. This extra money in the system is merely locked up in the banking system because demand for funds is anemic. In order for quantitative easing to be inflationary, the money needs to be chasing goods in the “real economy”. Bottom line is, aggregate demand is contracting at a vicious pace. Quantitative easing will not offset weak demand and the implosion of the shadow banking sector and we will continue to experience deflation until the economy has repaired its balance sheet. The question is, will the fed be able to mop up the excess liquidity when the money multiplier turns back into positive territory, I believe it will because it is merely residing in the banking system.

    Perhaps, though, the fed’s monetary policy (including the unconventional measures) is part of a more comprehensive strategy to devalue the dollar to improve the trade deficit. Unprecedented trade imbalances were part of the problem to begin with as they blunted the impact of Central Banks’ interest rate policies. An orderly devaluation of the dollar would go a long way toward correcting these imbalances

  14. Edward Harrison says

    I R James,

    The inflation is still there waiting to re-assert itself. When the demand for goods in the real economy reassets itself. Many economists are very disquieted by all of this. I am skeptical as to whether the Fed will be able to mop up the excess liquidity. As is former St. Louis Fed chair Bill Poole.

    In my view, all of this is a designed to lower the value of the dollar and inflate away some part of the debt burden. I will address this question in a future post. Andrew Lees of UBS has some interesting comments about FX strategy I would like to use for this.

  15. I R James says

    Look forward to your future post on this matter.

  16. I R James says

Comments are closed.

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