The FED, Interest Rates and Hoosier Bicycles

April 27, 2010

For release Tuesday noon April 27 and thereafter (747 words with optional cut)

This last winter the Federal Reserve System (FED) reported that it was raising the discount rate, a type of interest it charges bank, from .5 per cent to .75 percent. What does such action have to do with interest rates in Indiana?
 
Joe, who mows lawns, offers his brother Bill a loan of $100 to buy a bike on the agreement that Bill will pay him back $110 in one year. In this case, we have a lender, Joe, a borrower, Bill, the principle, $100, and a yearly rate of interest, 10 percent. Ben Bernake, chairman of the FED, is not consulted. From reading only the newspaper headlines, however, one might conclude that the FED controls interest rates. This not true.
 
Some states have a usury limit, which is highest rate that can be charged by one person, other than licensed financial organizations, lending to another. In Indiana, at present, there is no usury limit. If Joe and Bill do not specify the rate of interest and end up in court, then the Indiana “legal rate” of 10 percent could apply.
 
In formal financial markets, in Indiana and elsewhere, literally a million different interest rates prevail from the miserable .20 percent earned on shared savings at the local credit union to the egregious 22 percent payments on credit card balances.
 
Yet, economists, the press and folks in general talk about “the” interest rate.
 
It is helpful to think of a large number of different interest rates — car, mortgage, bond, CD, credit card, etc. — as threads running parallel inside the body of a snake. Slithering along a path, the body of a snake loops up and down.
 
Similarly, when interest rates in Terre Haute go up or down, interest rates in South Bend are sure to follow. Lenders in one area will place their loanable funds where they earn the highest return, and borrowers will seek loans offering the lowest rate of interest. The market arbitrages more or less to a single rate for a financial instrument with the same risk, time to maturity and collateral. The range of rates tends to move (with some lags) up and down together.
 
Interest rates not only converge geographically but do so as well between types of financial instruments. If many lenders are willing to provide funds for mortgages, the mortgage rate for borrowers is low. If some of these lenders decide to remove their funds out of the mortgage market and put it in another markets, for example auto loans, earning higher interest, then borrowers will pay higher rates on mortgages. Thus, the market keeps all interest rates moving within a band. Analysts, knowing that all interest rates move together, follow and report changes in just one or two interest rates. 
 
What causes the whole band of interest rates to go up or down? Changes depend on the supply and demand for loanable funds. If the demand for loans increases or the supply of funds decreases, interest rates will rise. If the demand for loans decreases or the supply of funds increases, interest rates will fall. Other than the FED discount rate, most interest rates are negotiated by borrowers and lenders in the market.
 
The FED does not dictate interest rates, but admittedly it has some powerful tools with which to affect them. (OPTIONAL CUT BEGINS HERE) The FED can increase or decrease the supply of loanable funds available in private markets. The rise in the discount rate suggests that the FED has begun to tighten up on the supply of funds. This could lead sometime in the coming months to higher interest rates in most markets.
 
Realizing that the FED influences but does not control interest rates is not merely an academic distinction. Given very low interest rates, it may be impossible for the FED to lower them further even if it wished to do so. Similarly, the FED may be unable to exercise any pressure on increasing interest rates if businesses and households refuse to borrow. Some economists believe that FED action follows rather than leads markets in determining interest rates.
 
In general, however, whenever the FED exercises its power to reduce loanable funds, interest rates rise. Why might the FED moving to take away the punch bowl now? The party has barely begun. Unemployment may not be increasing at the same rate, but it still exceeds 9 percent of the labor force. Purchasing orders are up, but property-for-sale signs still line the streets. Higher interest rates discourage business investment and consumer spending. Higher interest rates also increase the cost to taxpayers of financing government debt. Finally, interest rate increases are not politically popular. (OPTIONAL CUT ENDS HERE)
 
Why, though, would the FED act to discourage borrowing? The simple answer is that inflation, a sustained increase in the general price level, is rearing its ugly head.
 
High interest rates, initiated by the FED, are undesirable but inflation can be even more harmful to the economy, particularly financial markets. Would you be willing to lend me your money at a 5 percent mortgage to buy my dream home in Granger or Carmel when prices there are rising at 10 percent? Probably, not. You would either purchase the house yourself or provide your hard-earned savings to someone willing to offer an interest rate compensating you with normal return (plus the rate of inflation).

So if interest rates increase in the coming months it will be due to both a rising rate of inflation as well as contractions in the supply of funds engineered by the FED. Bill, if he really wants that bike, should accept the terms of brother Joe’s loan offer. Bike prices may soon increase. Also, Joe, considering higher returns offered elsewhere and realizing the credit risk of a loan to Bill, might just withdraw the offer.

Maryann O. Keating, Ph.D., a South Bend resident and an adjunct scholar of the Indiana Policy Review Foundation, is co-author of Microeconomics for Public Managers, Wiley/Blackwell, 2009.



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