Monday, August 27, 2012

What Is An Interest Rate?

Interest rates are the most important rates that exist. The best known, and most followed rates are the Federal Reserve Rate and the LIBOR.These rates are amongst the least risky rates in the Western hemisphere. 

To access the Fed rate, you must be a federally chartered bank. There are a lot of banks that look to the unaware consumer as a "bank." But there are significant differences between federally chartered banks, and state banks. 

Reserve rates for banks are set by the Fed. Reserve rates are important, because the amount of liquid reserves--cash, in most cases--determine the amount of money a bank is able to use for investments. Or, other uses. Like, loans. Banks are being regulated today at historically stupid levels, so, banks are using their funds to create the greatest possible returns, with the lowest possible risks. Purchasing federal notes are currently amongst the lowest risk assets that a bank can own. So, when an auction for notes comes up, banks are buying. And, with the current level of repo coming from Treasury, buying federal notes actually results in a negative interest rate. 

Between the Fed and Treasury, billions of dollars have been created; hundreds of billions. Since the U.S. has become the greatest holder of U.S. debt, fiscal policy has overwhelmed monetary policy. When you hear that the U.S. has a "fiscal cliff," part of the problem is that we have a fiscal (spending from the federal treasury) problem, and the other part is, there is so much cash in the system--held in part by Treasury--that when the economy begins a comeback, there is going to be "so much" cash that the system won't be able to halt the rush to inflation. 

Interest rates are the costs associated with choosing between cash and enterprise. Interest rates also have a distinct characteristic; interest rates measure risk. 

Today, the demand for cash is, and has been, at historic lows. Just as a sideline note, the current DOW levels, when taken as a measure of economic activity are deceiving, since there is so much cash in the market, that traders, flush with cash, are chasing stocks, looking for the greatest, short-term returns. We're building a new bubble in intangibles. Yet, when I last checked today, we're only three days from returning to what I believe are long-term trend levels; 11950 to 12950. All the cash in the system is based upon trading. And buddy, trading is different from investment. It isn't 1928. We all know that, at the margin, trades can make you money. And trading will continue after the bubble bursts. If you want to invest, buy land. God doesn't make any more of that. 

Interest rates are the cost of money. 

It wasn't that long ago that Oregon had an usury law. I think that under Oregon's usury law, lending institutions were limited to an interest rate of twelve percent. The Oregon State Legislature had determined--in order to protect the "consumer"--that twelve percent interest rates were sufficient to lending institutions. 

Usury is a word associated with evil guys, like Ebenezer Scrooge. 

The problem for Oregon was, at twelve percent, a major portion of Oregonians found themselves without a credit outlet. If you were alive, and aware, during the 1980's, you know that the interest rate being offered by banks was above seventeen percent. How much lending occurred at, or under, twelve percent?


When legislatures mandate interest rates, lending stops. Interest rates are the most important rates of any economy. Interest rates compare the costs of money. If you have money and simply hold money, the rate of interest you achieve is zero. If you have money and invest it, the rate of return can vary. Some times, the rate of return will be negative (below zero.) At times it will be positive (above zero.) Interest rates are easy to figure; given the return, divide by the investment. The larger the numerator, the smaller the denominator, the greater the return. 

Interest rates determine whether or not you should borrow money. At the same time, interest rates determine whether or not you should borrow money. (H/T

The single rule of interest that I'd like to leave you with  is risk. If a bank is willing to pay you a rate of interest for your deposit with that bank, as long as your deposit is less than $200-thousand, you have a basically risk less asset, with a positive interest rate.We haven't seen those days for years. 

Cash, today, is a risky asset. 

Why do you think that the value of gold has gone from 800 dollars to 1600 dollars? 


So, I'm done. Interest rates are the most important rates, or measure of economic activity, that exist. They are a reflection of how markets are doing--markets that produce real goods and services--and everything else. Interest rates reflect risk, which is why a 20-year old buying a used car pays a 20 percent interest rate on his loan, and a guy with a lumber yard pays 3 percent. The lumberyard guy is a better risk.

Legislation can affect rates. Simple borrowing between classes of borrowers show that a 20-year old used car purchaser presents a greater risk than a 50-year old lumberyard owner. 

Social Justice demands that each is treated in the same way. Common sense determines that interest rates are a function of a market, that rely on information that changes on a daily--if not momentary--basis.

Legislating interest rates doesn't work. They are that important. The most important financial data that exists.


MAX Redline said...

And, with the current level of repo coming from Treasury, buying federal notes actually results in a negative interest rate.

My expertise with numbers involves an ability to do a limited amount of programming in binary, but it has seemed to me that banks purchasing fed notes are presently losing money. So while there's little risk, there's no apparent upside unless interest rates increase or they can write off the losses, it seems to me.

I do recall seeing car ads in the '80's with low interest rates of 16%. Heck, the mortgage rate on my house was 11% (though only on a $40,000 balance).

I've also found it difficult to understand why people pursue the flawed concept of social justice - your remark nailed it.

T. D. said...

Yep. I remember when the average credit card rate for 20 somethings without equity was 18%.

In the late 1990's in Brazil the interest rate was astronomical going officially as high as 45% (though much higher for credit cards and such) in order to attract dollars and stop inflation. I have no idea why that didn't crash the economy, because business borrowing to expand was suicide, but it didn't. And official interest rates today are more in the 8% a year range.