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Guest Post: The "Person In The Street" Is Correct: The Fed Keeps Interest Rates Low

Submitted by Peter Cleppe of OpenEurope

The "Person In The Street" Is Correct: The Fed Keeps Interest Rates Low

On his new blog, former US Fed chief Ben Bernanke tries to explain that "the person in the street" is wrong to think interest rates are low because of the Fed.

He writes:

"If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed."

Obviously, the man in the street is correct: the Fed (or US regulation, for that matter) only allows certain financial institutions to issue money (legal tender) and it allows these to hold insufficient capital. If John has $10.000 in his bank account, which he thinks he can access and use any time he wishes, but the bank's capital ratio is only 10%, it means every single customer of the bank only really has 10% of what he thinks he can access and use any time.

That wouldn't in itself be a big problem in case the Fed would just let people suffer from parking their money in risky banks, but the Fed also acts as a "lender of last resort" in case a bank run would finish these irresponsible banks. Why would any bank then not engage in risky activity?

The result is a massive increase of the monetary mass, and as a result, the price of (future) money (the interest rate) is kept at a low level. That is how the Fed or regulators are able to influence interest rates, contrary to what Bernanke claims.

What's the use of this? Who has an interest?

Governments do not pay back their loans. They issue new loans to pay back the old ones. Who would ever lend to someone who engages in such practices? At least one would charge a very high interest rate to compensate for the risk.

When oceans of money are being created, it's not as risky any more to use part of it to lend to governments. When Freddy owns $10.000, it's risky for him to gamble with $500. When Sarah owns $1.000.000, $500 is to her what's $5 to Freddy. So the more money is being created, the more likely it will end up in the pockets of Ben Bernanke's political overlords.

In the case of the U.S., which thanks to its pool of capital, political and military power, enjoys the exorbitant privilege of having the world's reserve currency, an expansive Fed will not even necessarily "throw seniors under the bus", as one of Bernanke's critics once mentioned, suggesting that monetary expansion erodes life savings of senior citizens. A lot of the monetary expansion results in investment bubbles all over the planet. Some even have "credited" Bernanke with triggering the Arab "Spring", as food prices in the Middle East rose from mid-2010 to an unsustainable level after quantitative easing was re-started. It looks like Bernanke, or at least the institution he presided, is more powerful than he seems to think.