The dynamics behind interest rate policy
Undoubtedly, market values everywhere are predicated on the Fed cutting rates. To a limited extent, this could become a self-fulfilling prophecy. So far, the effect on the 10-year US Treasury Note, which sets the valuation tone for all financial assets, has been to reduce its yield in recent months from 4.7% to under 4.2% currently. I have pencilled in a potential support line at 4.08% (the pecked line).
While there is little evidence that this line will provide a floor to the yield, taking it as a reference point it should be noted that an anticipated cut in interest rates in September is mostly discounted. But because Powell appears to believe that inflation is coming under control, we should question this assumption. If Powell is wrong, then at best it will be only one cut at most before the uptrend in bond yields continues.
A History of Money and...
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Clearly, the Fed has little idea of what leads to inflation. The Open Markets Committee is only relying on questionable statistics of the past, because it appears to be clueless about the relationship between inflation and credit, and therefore the future course of the general level of prices.
Before Keynes’ invention of macroeconomics, it was widely understood that the expansion of debt for non-financial purposes was inflationary — more correctly it tended to undermine the value of existing credit measured in its purchasing power. A number of economists, such as Von Mises and banking experts such as Alfred Lansburgh, both having witnessed the European inflations in the early 1920s knew this. But following the publication of Keynes’s General Theory and particularly in this post-Bretton Woods era, the economics profession is in denial.
We can quantify inflation trends approximately by adding together additions in government and consumer debt, because these are undeniably unproductive debt. And we must incorporate changes in the volume of savings: if savings increase, immediate demand for goods declines, but if they decrease they become an additional source of inflationary pressure. The result is shown in the table below.
Far and away the most important factor is the budget deficit, adjusted for the change in its cash balances at the Fed. We see that the Federal Government’s deficit spending injected a net $2,250,094 million into the economy allowing for the change in the general account balance. Altogether, non-productive debt diluted existing credit in the form of GDP by 9.23% in the year to March, allowing for the diversion of savings to consumption.
Monetarists tell us that an expansion of money supply feeds through to price increases over a year to eighteen months period, consistent with the Cantillon effect which describes how extra currency in an economy benefits the issuer first and most, then progressively undermines its value as it is absorbed into wider circulation. On these grounds alone, we can see that the Fed’s belief that inflation is coming under control is a gross error of judgement.
The importance of the relationship between a budget deficit and price inflation cannot be overestimated. While these figures reflect the second half of fiscal 2023 (to end-September) plus the first half of the current fiscal year, be in no doubt that the budget deficit trend is increasing. The base case evidence for consumer price inflation is that it is not only considerably higher than the CPI statistics indicate, but it will continue to increase, particularly under President trump Mark 2. Therefore, hopes for sustainable reductions in interest rates are badly misplaced.
The problem with monetarism
“If the practice persists of covering government deficits with the issue of notes, then the day will come without fail sooner or later when the monetary systems of those nations pursuing this course will break down completely.”
Stabilization of the monetary unit from the viewpoint of theory — Von Mises
So wrote Ludwig von Mises in 1923, at the height of the German inflation. In the same essay he went on to write,
“Thus, it is easy to understand that as long as the continuation of monetary depreciation is expected, the money lender demands and the borrower is ready to pay higher interest rates.”
Put so succinctly by von Mises, there should be no excuse for not understanding the source of currency depreciation and that lenders will only be prepared to lend if they have sufficient compensation for it. Yet today’s entire capital market system ignores this reality.
I shall not belabour this point any further but will now address the fallacies in monetarist theory. We can all agree that an expansion in the quantity of credit dilutes a currency’s purchasing power, but this effect is offset by credit which is deployed in profitable production demanded by consumers. Put another way, a progressing economy needs credit to progress, and progress gives consumers profitable employment together with lower prices and an improved standard of living. I use the term progress rather than growth, because growth includes the deployment of credit for inflationary means.
Monetarism makes no such distinction. It is purely mechanical in its application. Nor does it make any allowance for the subjectivity of a currency’s users in its valuation. But this is at variance with the obvious truth, that the value of a currency depends on the judgement of its users. This is evident when the general level of commodity prices in a currency changes — clearly this can only be the case if the value of the currency alters in the opposite direction from commodity prices. While changes in the currency’s quantity obviously have an effect, the effect is incorporated in its subjective value.
Indeed, it is confusion over subjective influences which has contributed to monetary policy committees dismissing monetarism. But instead of attempting to understand the importance of subjectivity in market valuations, they persist with guidance from statistics which are history, self-serving in their inaccuracy, and wholly irrelevant to the task. The importance of this point is that attempts to suppress interest rates inevitably lead to a loss of faith in a currency with greater negative consequences for the future than a monetarist would expect.
Two policy paths leading to the same outcome
The problem for leading central banks is that persistent budget deficits exacerbated by interest rate suppression guarantee higher interest rates for longer, undermining the finances of governments, consumers, zombie corporations, and credit agents alike. It has even brought a state of bankruptcy to the central banks which additionally inflated their currencies through quantitative easing. They now face an existential reckoning from which there is no escape.
The Origins of Money
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If central banks permit markets to determine interest rates and bond yields, the condition of entire financial systems will deteriorate to the point of implosion. This provides us with a stark illustration of the independence of a currency’s value from monetarist theory. In a credit crisis encompassing the government and the financial system, there is the prospect of widespread debt defaults. All credit depends upon matching debt obligations: if those obligations become worthless, then so will credit.
The value of credit collapses with the debt, and credit includes currencies as well. The collapse involves no further issuance of currencies. The danger of such a catastrophe facing the dollar and other major fiat currencies today cannot be overestimated. Starting with a US Government debt to GDP of about 130%, high and rising interest rates alone will prove fatal for the fiat dollar’s value in terms of goods and services.
The alternative to higher interest rates is what investors currently hope for, any excuse to continually suppress interest rates. They reason that lower interest rates would encourage a combination of asset valuation benefit and the return of economic confidence. But while superficially attractive, interest rate suppression will ignore the evidence of a continuing deterioration in the currency’s purchasing power. Furthermore, as pointed out in the second quote from von Mises’ essay above, the commercial reality is that whatever monetary policy dictates, markets will demand higher, not lower interest rates.
It is hardly surprising, therefore, that prescient foreign creditors faced with this Hobson’s choice for the dollar are opting out of dollar credit and into gold, which in everyone’s common law is legal money without counterparty risk. It is a flight which is only just beginning in earnest and has yet to be understood generally by domestic users of their currencies. When they do finally appreciate that the crisis is one of a collapsing currency, they will dump it for goods and commodities simply to be rid of it.
Reprinted with permission from MacleodFinance Substack.
