The Fruits of Civilization (31-1) Interest Rates

Interest Rates

An interest rate is the percentage return a monetary lender makes from a borrower. An interest rate is, in essence, the price of holding money.

Swedish economist Knut Wicksell imagined that there was a “natural rate” of interest.

This natural rate is roughly the same thing as the real interest of actual business. A more accurate, though rather abstract, criterion is obtained by thinking of it as the rate which would be determined by supply and demand if real capital were lent in kind without the intervention of money. ~ Knut Wicksell

In the late 19th century, Wicksell saw financial rates set by banks competing to make loans. The job now falls to central banks, which still think in Wicksellian terms: the natural rate prevails when the economy is at full employment. Set the policy rate above the natural rate and the economy tips into recession. Set it below, and inflation or speculation sets in.

Nowadays, the natural interest rate is often assumed to be constant. American economist John Taylor created a rule in 1993 which central banks might use to set the interest rate based upon the current rate of inflation, so as to steer the economy financially from either the shoals of doldrums or speculative bubble blowing. The Taylor rule took 2% as the real natural interest rate.

(The Taylor principle prescribes that a central bank set the nominal interest rate slightly above rising inflation or slightly below falling inflation, so as to foster price stability and engender the credibility of the central bank via consistency and predictability, thus lessening uncertainty over government policy. Central banks do not explicitly follow the Taylor rule, instead preferring to play it by ear.)

That would have been a hard sell to Wicksell, who thought the natural rate is “never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low and expected to remain low.”

The nut of Wicksellian philosophy regarding the natural interest rate is that it varies by expectation, in context of the current economic environment. Financier responses to central banks jiggling interest rates have shown that to be apt. In actuality, central banks key one eye on inflation and the other on how they think the market would respond to a change in interest rate. Central bank policy toward interest rates is played as a game of expectations.