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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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    • stanfrommarietta profile image


      5 years ago

      Good essay, John. I'd like to add that bonds (or Treasury securities) are used for other purposes. You mention that bonds are sold to investors, like the Chinese, Japanese and other foreign holders of dollars acquired in selling their goods and services to us. The investors use these as you say to park their dollars in a safe location. They do not want to buy things from us at the time because their imports were used to balance against deficit spending. Imports take dollars out of circulation and are parked initially in foreign exchange banks. Frank N. Newman, a former leading bank executive and assistant secretary of the Treasury under Clinton says these dollars actually do not leave the dollar banking system. But they are taken out of circulation until used to buy something with them. The bonds thus act as Certificates of Deposit, CD's linked to time deposits at the Federal Reserve Bank. The irony is that these bonds are counted in the national debt figure, and people assume that the government has used their money to fund its operations, with the risk that the government may not be able to get taxes to pay them back. This is false. The government will also sell bonds to fund deficit spending. Usually the implied debt there is rolled over by replacing mature securities swapped from the Treasury. This processes of rolling over the debt can go on perpetually. The interest today can be acquired without taxes by selling bonds to banks to acquire money to be used as interest. The Federal Reserve can buy these bonds from banks to redeem the debt for the interest money, and the Fed buys with money it creates out of thin air. The point is that about half of the bonds are matched by time deposits of investors who hold securities linked to their deposits. When the bonds mature the Fed can either return the time deposit to its investors, or if the investors do not want the money at that time, the Fed can swap their mature securities for new ones with new future maturity dates. Interest is created out of thin air by the Fed.

      The government benefits from selling these bonds to investors. It takes the dollars out of circulation, preventing their contribution to inflation, if up to that point deficit spending was being balanced against imports, avoiding excess growth in the money in circulation. (Fiscal policy concerns balancing spending against tax revenues; but modern governmental finance also balances government spending against savings, and imports which take money out of circulation also).

      The Fed buys securities/bonds for two purposes: (1) fight deflations (recessions or depressions) by using money it creates out of thin air, which can get into circulation if banks create new loans (new money out of thin air also) using their reserves (where Fed deposits the money) as backing.

      If the securities were used to fund deficit spending, when the Fed buys them from the banks that redeems the government's debt to the banks for the deficit money. So, ultimately the debt can be redeemed for deficit spending, meaning the ultimately deficit spending money is regarded as debt-free, either in the case where Fed redeems absolutely the debt or when the Treasury perpetually rolls over the debt with securities swaps.

      (2) The Fed will buy securities for another purpose: It needs them to sell. It sells them during inflations to banks and investors to take money out of circulation. It buys them during deflations from banks. To fight inflation possibly resulting from creating too much dollars during full production and full employment (which cannot increase by mere spending of money), the Fed needs a supply of securities to sell to banks, which it will require banks to buy to drain their reserves of excess dollars. Hence the buying of securities by the Fed.

      The Fed seems not to wish the public to correlate its buying securities with buying particular securities, such as those used for deficit spending. It times its buying and selling of securities to when there are deflations and inflations, respectively. But when it buys a security used for deficit spending it automatically makes the money spent on deficit spending resulting from this security to the bank by the Treasury, debt-free money.

      In MMT theory this corresponds to a situation in which the government through its Treasury may simply create the money needed to cover the deficit. It actually did that from about 1862 to 1917, beginning with Pres. Lincoln who went to the banks asking what they would charge in interest for loans to fight the civil war. They wanted between 25% and 36%. He refused to pay such usurious interest and said, effetively, "Nope, I'll print my own," and these were known as greenback dollars or Treasury Notes. Today dollars created by the Fed are Federal Reserve Notes. In 1917, the banks, after lobbying Congress for years to force the Treasury to borrow money from them to cover deficits, succeeded in prohibiting the Treasury from creating its own money out of thin air. This created for the banks a perpetual stream of interest money paid by the Treasury or the Fed to the banks.

    • JohnfrmCleveland profile imageAUTHOR


      7 years ago from Cleveland, OH

      First of all, try not to think of the bonds as "debt." The U.S. government creates both dollars and bonds out of thin air. When they need to pay their bills, they print up dollars to pay them. By law, we are required to sell bonds in the same amount as our deficit spending, but this law is a relic of the gold standard days. Today, bonds are actually an unnecessary part of the equation.

      A government can print more money if their economy is productive enough to meet the demand enabled by the new dollars. Russia was not, and when they overcreated rubles they lost their value. And I'm not sure about this, but I believe Russia had some foreign-denominated debts at the time, and those debts had to be paid off with real value - meaning, as the ruble sank in value, it took more and more rubles to pay them off. (America owes no foreign debts.) Same goes for the Weimar Republic - not enough production, plus foreign-denominated debts, and the result was demand-pull inflation.

    • greenraiderskee profile image


      7 years ago from Isle of Wight, England

      I remember back in the late 90s , I think Russia defaulted on its domestic debt. I can`t remember the full details though. So what your saying John is that a country can just print more money to pay off the debt owed through the selling of bonds?

    • JohnfrmCleveland profile imageAUTHOR


      7 years ago from Cleveland, OH

      Greenraiderskee, thank you for your comment.

      Government bonds in fiat currencies are, in theory, 100% secure. The only possible danger of default is political, as in our debt ceiling fiasco. A country would have to choose to default, which would be both crazy and stupid, as we have no operational problem paying any and all dollar-denominated obligations.

    • greenraiderskee profile image


      7 years ago from Isle of Wight, England

      nice work John, its a very shady business! The way things are going I wouldn't be surprised if government bonds are no longer 100% secure. Regards Pat


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