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People usually have only a passing idea as to how inflation and interest rates actually work in the real world. This is so, because thanks to Central Banks and the Fractional Reserve System (aka funny money), the interaction between multiple, occult, and inscrutable processes determine their levels.  Senseless Inflation and Interest Rates have become the norm this days and have been embraced with by all mainstream media.

Interests are going up because we have lower inflation, unless they will go down because the rate of inflation has decreased, unless, that is, the Central Bank takes steps in to increase the purchase of bonds but rise the reserve requirements, and if consumption levels are maintained or supported by the psychological effect of the announcement, and there is no fixed exchange rate, but in the case they liberalize it through clearance mechanisms, it may turn around and invert the bond curve, in which case they may go up… or down. Clear now?

Many of the announcements out-there in the real world sound like that. You would need a PhD in Economics just to understand the jargon, and probably a Master’s in Statistics and Psychology to understand their motivations.

Before we embark on a voyage of clarification, let’s be clear. The gigantic mess we are going to describe rests squarely on Central Banks (CB). They are the sole culprits. Let’s begin.

Interest Rates are complex processes that depend on many factors. What’s worse, these factors change over time, are contradictory and are also dependent of Interest Rates! Therefore, one must be very careful when making analysis because what trended up yesterday may trend down today.

There is one general truth about Interest Rates:

Interest Rates increase with the demand for credit and decrease with the supply of credit.

To understand this truth, all we need to do is to think of Interest Rates as a price for a commodity called money. The more money there is available, the lower its price (lower Interest Rates). The less money there is available, the higher its price (higher Interest Rates).

This is simple supply and demand.

Where it becomes interesting, is when we look at where money comes from and what it does. To be more precise, money is the underlying commodity for credit. Credit is the offer to loan a certain amount of money for a price, the Interest Rate.

 

The Beginning

When a CB wishes to “stimulate” an economy, it takes steps to ensure Interest Rates drop. If the price of borrowing money decreases, companies will borrow more and therefore jump-start the economy.

In order to drop Interest Rates, a CB goes to the market and purchase bonds from Banks, with cash that it created out of thin air. Let us assume that the total purchase was of 0.5 Giga dollars. This cash is now sitting in Banks’ electronic volts. Banks, in turn, are allows to create more credit (read cash) out of thin air to the approximate proportion of 1 to 10 in terms of “reserves” (i.e. electronic ones and zeros the CB just created). Now Banks have 0.5 Giga dollars more than they had before which they promptly transform into 5 Giga dollars through the magic of the “fractional reserve system” (aka funny money).

These 5 Giga dollars of credit are now sitting idle in Banks’ accounts. But Banks are in the business of making money through Interest Rates. So, they loan those 5 Giga dollars to companies. The problem is that all the Banks are in the same position. They all sold some of their bonds to the CB. Which means that they all have “excess” reserves sitting idle in their electronic volts. Which means that they will all go out to the market simultaneously and offer loans.  We suddenly have an excess of offers and, like with anything else, when we have more of something being offered in a market, its price drops. Supply and Demand.

As the “price” of borrowing money is the Interest Rate, it drops.

 

The Middle

Voila! Cheap money. Forever!

Well… not so fast.

In absence of any CB, Interest Rates are determined to a large degree, by the level of people’s savings and consumption.  Look at it in this way. The more people save, the more “reserves” are in the Banks. The more reserves, the more funny money the Banks are allowed to create. The more money to lend they have, the lower the Interest Rate.

The opposite is also true. The more people consumes, the less reserves are in the Banks and therefore the less money they have to loan. Less money implies higher Interest Rates.

And so, to a degree, when a CB injects money into the Banking system, they mimic savings, since the Banks have more reserves. However, these fake savings are not equal to real savings.

In the case of real savings, the total amount of money in the system does not change. In the case of CB intervention, the amount of money is increased enormously.

And what happens when we have more money chasing the same amount of goods? You guessed it! Prices go up. Voila! Inflation.

Higher inflation means that you would need to earn more money in order to buy the same goods. Banks are not stupid and notice this. Therefore, they raise Interest Rates (aka profits) in order to compensate for the decreased purchasing power of CB injected money.

And so, if CB’s want to keep Interest Rates low, they need to repeat this cycle indefinitely. They need to keep injecting “fresh” (aka new) money into the system for as long as they want to keep Interest Rates low.

At this stage, the market can’t see or differentiate between genuine savings and CB injected fake savings. All the market see is cheap money, so they borrow. All this borrowing creates an artificial boom since it makes possible enterprises that normally would not be financially sound.

 

Towards The End

After a while, something else takes place. People gets wise. They realize that prices are going up and up and up all the time. Bankers begin to anticipate inflation and so they raise Interest Rates far beyond of the real level of CB injected money. They want to stay ahead of the money printing deluge.  If they would not done so, they would go broke since due to inflation, the purchasing power of the money keeps dropping.

Think of it this way.  A Bank loans money at 5% annual. With that 5% they can buy a new building. However, as inflation rises the building begin to cost 6% and then 7% and then 8% and so on. So, even with their 5% profit, they are actually losing money because they can’t purchase what they could before. And so Banks start racking up Interest Rates to compensate for inflation.

And how about people? Why would people borrow at higher Interest Rates? Because they hope the inflation will be higher than the Interest Rates and that they will be able to pay back the loan with devalued money.

Think of it this way. I borrow money at 5% from the Bank to buy a car and I need to repay the loan in one year. But the annual inflation is 15% (the Bank miscalculated) .

At the end of the year, I pay the loan back to the Bank, but using money that is 15% less valuable. So the calculation of how much money the Bank lost si simple: 15% - 5% = 10%. The Bank should have made a profit of 5%, but instead it lost 10%.

Please take into consideration that this loss happens in terms of purchasing power, not in terms of absolute monetary value.

Let’s say that I borrowed 10.000 dollars to buy a car. At the end of the year, I need to return 10.000 + 5% = 10500 dollars. This is exactly the amount I return. The problem is that after a year those 10000 dollars can only purchase goods and services for the equivalent of 9000 old dollars (10000 + 5% - 15%).

For Banks, this is a problem because they have less money to lend. If there would be no inflation, 10000 dollars at 5% over a year yields 10500 dollars. The Banks would now have 10500 dollars to lend.

However, as we have inflation, the Bank’s 10500 dollars are only valued at 9000 of the previous ones. And so, somebody wishing to borrow sufficient money to buy a car, would now need to ask for 11500 dollars (15% inflation). As the Bank only has 10500 dollars, they cannot do so and go broke.

And so, by now people have learned that more CB interventions implies more easy-money, which will eventually generate more inflation. Therefore, prices go up in anticipation of inflation. As prices rise, so do Bank’s Interest Rates which are trying to stay ahead of inflation.

This is the exact contrary effect that we saw happening before. In the beginning, CB injections lowered Interest Rates. In the end, CB injections rise Interest Rates.

 

The End

The end usually comes when Interest Rates are so high and they keep rising so fast that no manufacturer can stay ahead of this speed. So, companies act rationally. They only have two choices. They either rise prices astronomically (and so nobody can afford to buy their product) or they go out of business altogether. Voila! A brutal recession.

Or, CB’s stop the perennial generation of easy-money overnight and then Interest Rates really skyrocket (remember? Less money = higher Interest Rates). Yet another brutal recession.

Is this The End? Not a chance.  Don’t miss the second part of this lesson.

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Senseless Inflation and Interest Rates - Part 2

 

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