Can the Federal Reserve "Really" affect interest rates?

At the end of When is an Investment not an Investment I talked about the inevitable rise of real interest rates once the RBA has finished lowering them by printing money. It’s now time for a discussion on real and nominal variables. While this isn’t totally necessary to understand the next article, it does highlight an interesting anomaly: a lower interest rate at the bank shouldn’t necessarily induce anyone to borrow more.

In So what’s the best way to hedge against inflation? I talked about how nominal interest rates (the full interest rate quoted by banks) are made up of two components (check out paragraph three for a recap). The “expected inflation” component is simple enough to undertand, but businesses generally don’t care about this. Once you borrow money, inflation in a funny way is your friend (making Ben Bernanke your hero). Just as the dollars that Rob Mariano won in 2010 weren’t worth as much as the dollars his wife won six years earlier on Survivor, the dollars that businesses use to pay back their loans years later are not worth as much. To understand this abstract use of the term value think which dollars you rather have, the ones that Rob was given, or the ones that Amber was given six years earlier, that could buy more goods. Businesses that borrowed in 2004 got Amber’s dollars, and the banks that lent the money were getting Rob’s dollars back in 2011. So if the nominal interest rate rises (and hence your nominal borrowing costs rise) but expected inflation rises as well, they tend to cancel each other out, and the real cost of borrowing hasn’t changed. What’s left is the real interest rate that businesses need to be concerned about. This relationship holds virtually one to one. If the expected inflation rate falls by one percent, the nominal interest rate tends to falls by one percent, but businesses have no incentive to invest further, even though the nominal interest rate has fallen. In the long run lenders face the same trade off. If their inflation expectations rise they will be happy as long as nominal interest rates rise to compensate them (one percent higher inflation, one percent higher nominal interest rates). you can see that even though the nominal interest rate has changed, no one has borrowed more or saved more. The nominal interest rate is (approiximately) equal to the real interest rate plus inflation expectations.

Its only when that residual, the real interest rate, changes that there is an incentive to move money. This residual is simply determined by borrowers and sellers getting together and deciding on an interest rate in the market: it is determined by the demand for and supply of savings. It should be becoming clear now that it is not controlled by the central bank, at least in the long run. So what’s the best way to hedge against inflation explains how investors vote with their feet and determine interest rates. In the short run the RBA can print money and lower nominal rates as in The Wonderful Central Bank of Oz (which, holding all else equal lowers real rates) but rates will eventually rise back to their original level to maintain the real interest rate, and then a little bit more to compensate savers for the extra inflation from the additional money printing. The primary point to take away is that the real interest rate hasn’t changed.

This illustrates, and this is common, accepted, mainstream economics, that the reserve bank can only affect the real interest rate and borrowing in the short term. Any investment made at the lower interest rate thanks to the Central Bank will be unprofitable when things normalise.