“Low Rates Still Needed”, So Says Our Central Planner

Posted by Jason | Posted in Economics | Posted on 25-02-2010

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Will Bernanke be raising rates anytime soon? Sure doesn’t look like it.

After taking several small steps recently to take the financial system off life support, Federal Reserve Chairman Ben Bernanke made clear Wednesday that he wasn’t close to the more momentous act of raising interest rates, thus tightening credit.

In his semi-annual testimony to Congress on the economy and monetary policy, Mr. Bernanke said that short-term interest rates, now near zero, were likely to remain there for at least several more months.

He highlighted worries about what he called the “nascent recovery”—marked by high unemployment, wobbly real-estate markets, weak lending and large budget deficits. Mr. Bernanke said slack in the economy meant the benchmark federal-funds rate would remain near zero for an “extended period.”

Fed chairman Ben Bernanke will update Congress on monetary policy this morning. The question-and-answer session might prove illuminating, Kelly Evans reports on the News Hub.

via Bernanke: Low Rates Still Needed – WSJ.com.

OK, so if Americans tossed aside the assumptions that are programmed into them by the media and schools, they would ask, “How does Bernanke know when the rates need raised?” Well, the truth is he doesn’t.

Just think about this whole concept of central planning when it comes to interest rates. Interest rates are just the cost of money. It should be set by supply and demand just like the cost of any other product or service. So, what would have happened if Bernanke didn’t crank interest rates down to zero to fix the bubble the Fed just created and popped? Well, rates were high because the Fed raised them before the bubble burst, which ultimately popped the bubble. Now, let’s say the Fed disappeared off the face of the earth at that moment and the free market took over. Interest rates would have been high at the moment just like it was. When the interest rates are high people save instead of spend. If for instance you are looking to invest in a building and your return is 7% but interest rates are 6%, are you going to spend that money or save it? You are better off saving it than taking the risk for an additional 1% return.

Now, with an increase in savings and a decrease in borrowing, what would happen? What happens anytime supply (money in this case) increases and demand (borrowing in this case) decreases? The price (interest rates in this case) declines. As it declines, all the sudden that investment in a new building makes more sense, and at that point you will have real investment based on real economic conditions. The interest rate will actually mean something, and you will know that currently based on the interest rate there is ample supply of money in savings to be lent out to fund this project. The funding will not dry up at the whim of the Fed half way through the project.

Now the opposite is true as well. If too many people start borrowing instead of saving, the interest rate will increase. With less savings, supply (money) decreases. When supply decreases and demand increases or remains the same, what happens? Prices (interest rates) go up.

The market can handle money and interest rates based on real conditions. Instead, much like the Soviet economy, we have a central planner who has no clue what the real conditions are. Think about it. When the economy tanked, people should have stopped borrowing/spending and began saving. That would have lowered interest rates and got investments back on track after savings was back up to a sustainable level. Instead, the Fed dropped interest rates to the floor (actually negative real interest rates), which discourages savings. Is it any wonder our economy seems to have booms and busts? Businesses decide to invest assuming that there is ample supply of money. The problem is there was no real savings, because the Fed’s zero percent interest rates discouraged savings. Then some point in their project, the Fed decides they want to raise interest rates, and funding for that project dries up. This is not based on real market conditions, but because the Fed said so. Now this business lost it’s investment, which can ultimately lead to bankruptcy, laying off employees, etc.

Hopefully this makes sense. I’m not an economist, but sometimes I play one on this blog and not a very good one.

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