Interest rates – raise or lower, do they matter

I saw an article this morning about a few people calling on the Fed to raise interest rates by 2 percentage point. Here is a link to the article.
http://www.bloomberg.com/news/2010-08-22/bernanke-must-raise-benchmark-2-points-in-prescient-rajan-s-latest-warning.html

If you read the article, you will see my yawn on it. You can keep arguing this way or the other and still make sense. This is because these guys talk purely from a monetary point of view and don’t talk about the fundamental hinge of an economy, which is the exchange of goods and services. If all you talk is dollars, interest rates, Fed’s balance sheet etc, you can argue for any monetary policy. Greenspan can argue that the Feds can’t do anything about asset prices but they certainly can do something about the underwriting standards of loans – it is not the low interest rates that fuelled the asset bubble in the US (it may have abetted it) but the asset bubble was created thru NiNa loans and really poor underwriting standards. You can have an asset bubble even in a high interest rate environment if the banks were willing to lend without any proof of income generating capacity.

It is worth asking why even have an interest rate in an economy. Interest rate is needed because the person who has saved money (or who has underconsumed) will not lend the money without seeing value for it – an interest on the loan provides the value. In a large economy, to have an efficient way to lend money, we have institutions called banks to collect deposits and lend money. The bank is the intermediary for us to lend to people who need the money. Why does somebody need to borrow money – because they have to pay for resources now before they can generate a profit. A company can borrow money thru different ways and a bank loan is just one mechanism – equity capital is another.

High interest rates are associated with high inflation. People are willing to borrow at high interest rates because they know they can pay it back with rising prices of their products. If their profit margin is 10% on a sale of $100, it would be $10 of profit. If the profit margin remained the same and the sale price inflated by 10% to $110, the profit will now be $11. So the company has the extra $1to pay a fixed rate loan from last year.

Low interest rates are associated with low inflation. But the interest rates are just responses to an inflationary or deflationary environment. Why does inflation happen – because the people demand more of the products than what can be supplied by the economy. If there is a supply glut, very hard to create inflation.

If you do a zero interest rate, you can theoretically kill the morale of an economy and create zombie banks. In a zero interest rate, nobody wants to lend and so borrowing can't happen (unless the Fed funds the borrowing) but if the borrowing doesn't happen, you could choke new supply coming on line and hopefully that will create an excess demand over supply eventually. But the process to get thru the excess supply will be so excruciating that the govt won't allow it to happen.

Let me talk more on this subject in my next blog.