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Why Interest Rates Aren't Going Up

Updated on October 16, 2013

Why Interest Rates Aren't Going Up

Quick answer: because the government controls interest rates, and presently, they want the rate to stay low.

Here's how they do it:

When the government issues bonds, they don't do it to raise money (which they can simply print up), they do so for the purpose of controlling the interbank interest rate, the rate at which banks borrow excess reserves from each other to meet their reserve requirement. If they want to raise the interest rate, they can auction off an excess of bonds, bringing down the bond price and raising the yield. Or, if they want to keep the rate low, they can auction off fewer bonds, which drives up the bond price and lowers the yield. If necessary, they can bid up the price and buy the bonds themselves. Since the government creates both dollars and bonds out of thin air, this is purely a book operation and costs them nothing.

Banks are big buyers of government securities. When they have excess reserves, banks buy these securities to earn a bit of interest (reserves only earn 0.25%) while parking their dollars in a perfectly safe place. No other investment offers 100% security. And U.S. government bonds are 100% secure, regardless of what Standard & Poor's rates them at. Buyers certainly weren't deterred by the downgrade.

A Word About How Banks Operate

Remember learning about the "Money Multiplier" in college? How banks first amass funds, then loan out 10x that amount, using those hard funds as a reserve requirement? Well, that's not how banks actually operate.

In real life, banks make whatever loans they are able to make, then take care of the reserve requirement later. They have a 3 day float - for example, a bank will calculate their reserve requirement at the end of Tuesday, but they will have to meet that target on Friday. If they hold insufficient reserves, they borrow excess reserves from other banks at the interbank (overnight) rate, which is basically the same as the yield on government bonds. If they hold excess reserves, they can either loan those funds to other banks at the interbank rate, or they can invest in government securities. And if banks cannot get the reserve funds they need on the interbank market, the government will simply loan them more reserves.

The take-home lesson from all of this is that banks are never reserve-constrained. If some creditworthy borrower comes along and wants to borrow money, it doesn't matter if the loan business is so hot that no other banks have excess reserves to lend. The bank can still make the loan, and borrow reserves from the government. So there is no "market" for loanable funds, either! (Remember that, because that goes against everything that the conventional wisdom tells us.) There is not a finite pile of funds to be loaned out, because the government can always provide more reserves, and banks can always provide more credit. And since any bank can avail themselves of those reserves, any bank will be able to loan you money. The banks only need to make a bit more interest over and above the interbank rate, enough to make it worth their while, and the lowest bidder will win your business.

...and that's why interest rates aren't going to go up until the government makes them go up.


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