Why should central banks cut interest rates?

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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.

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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.

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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

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