| | Steve,
I wrote, "Inflation raises all interest rates, the federal funds rate, the discount rate, and the prime rate." You replied, I have to disagree with you. There is no question that the rate of inflation is an important consideration for any private lender, but the government's interference is so massive that banks currently borrow from the government at interest rates that are FAR BELOW the rate of inflation."
The government's stated inflation rate (which understates actual inflation rate) is hundreds of times higher than the fed funds rate and we have seen the fed lower the interest rates in hopes of offsetting the credit contraction while at the same time they inflated the money supply. Good points, Steve. You are correct; the federal funds rate itself is often below the rate of inflation. It was evidently Volker's raising the Fed Funds rate In 1981 that caused it to be higher than the rate of inflation. I had forgotten about that. However, before Volker became Fed Chairman, the Federal Funds rate was already almost 11%. What is interesting is that by selling Treasuries and withdrawing money from the economy, he had to raise it as high as 19% in order to have the desired effect of stemming inflation. I'd be interested in what you think of the following comments by Milton Friedman on this issue: He was asked the following question:
"1. Given the Fed’s ability to influence the federal fund rate, why doesn’t the fed simply set its target at a low level – say 2% - and just keep it there?" He answered:
"In order to carry out such a policy beginning with a situation in which the federal funds rate is 5.5%, the Fed would have to engage in large scale open market purchases. That would set in motion a rapid increase in the quantity of money, which, in turn would lead to a rapid increase in total spending, and after an interval, inflation. The demand for loans, including for federal funds, would zoom. Upward pressure on the federal funds rate would mean that the Fed would have to engage in larger and larger purchases to keep the federal funds rate at 2%. The result would be hyperinflation.
"What this hypothetical example indicates is that while the Fed can at any time influence the federal funds rate, it cannot set it wherever it wishes without unacceptable results. If it could, the federal funds rate would never have been over 19% in some months of 1981."
Hmm.
A second questioner asked:
"2. Economists talk about a “real interest rate”. What is that?" Friedman answered:
"The interest rate adjusted for inflation. Suppose you lend $100 for a year at 5% interest, so at the end of the year you would receive $105. If prices have risen 3% during the year, the $105 will buy only as much as $102 would have purchased a year earlier. You have realized a real interest rate of 2%. High nominal interest rates (like the 19% federal funds rate in 1981) almost always reflect high inflation."
Another question:
"3. Newspaper accounts tend to take it for granted that a change in the target federal funds rate affects other interest rates in the same direction – including even the rate on mortgages. Is that true?
"Different interest rates do tend to move together, but the correlation is far from perfect. A change in the Fed’s target rate has no direct effect on other rates, though it may have an indirect effect through altering the expectations of borrowers and lenders. More important, Fed open market purchases of government securities to enforce a reduction in the target rate add to bank liquidity. That increases the availability of loans, which tends to lower interest rates across the board, particularly on short-term loans such as three-month treasury bills, or commercial paper. However, it also tends to stimulate the economy. That increases the demand for loans, which tends to raise interest rates. The latter effect becomes dominant if monetary expansion is continued at a high rate. As a result the immediate and long-run effects of monetary policy on interest rates generally are in opposite directions." (Emphasis added)
(Edited by William Dwyer on 6/04, 8:37am)
|
|
Throughout the Bush and Clinton presidencies, Alan Greenspan, a disciple of free-market economist Friedrich Hayek and an avid reader of Ayn Rand, had served as chairman of the Federal Reserve Board. Greenspan had lived through the Ford/Carter inflationary years and had watched with concern the rise of federal deficits in the 1980s. Early in Clinton’s term, while interest rates remained low, the president took an action that dictated the behavior of the Fed and its chairman for the entire decade. In order to show rapid progress against the “Reagan/Bush deficits,” Clinton refinanced large chunks of the national debt at the lowest rates possible, regardless of the length of maturity. Much of this consisted of short-term bonds; but it had the effect of reducing the interest paid by the government on the debt, thus giving the appearance of reducing the deficits. By doing so, Clinton refused to refinance the debt in much longer term securities at a slightly higher rate. As long as inflation, and therefore, interest rates, stayed low, it was a good deal for the country. But the slightest uptick in inflation would add billions to the national debt and raised the specter of a massive refinancing of the debt at much higher prices. Clinton’s action in essence locked the Fed into a permanent antiinflation mode. Any good news in the economy—rising industrial production, higher employment figures, better trade numbers—might cause prices to go up, which would appear on Greenspan’s radar detector as a threat. The chairman found himself raising the prime rate repeatedly, trying to slow down the stock market. It was a perverse situation, to say the least: the most powerful banker in America constantly slapping the nation’s wage-earners and entrepreneurs for their success. Worse, Greenspan’s actions resulted in a constant underfunding of business, a steady deflation affecting long-term investment. Although few spotted it (George Gilder and Jude Wanniski were two exceptions), the nation suffered from a slow-acting capital anemia. 
