Interest II

 

The Twelve Days of Christmas

On the third day of Christmas
My true love sent to me
Three French hens
Two turtle-doves
And a partridge in a pear tree

And Gaul is divided into three parts. And a story has a beginning, a middle, and an end.

I have previously agreed that Three is a Magic Number, so let’s divide interest into three parts:

1.      The discount rate,

2.      The currency rate, and

3.      The product rate.

The discount rate is how much you value the future. The future should always be less the present, i.e. “a bird in the hand is worth two in the bush”, which means that the discount rate should be greater than 0. For example, if the future is worth 90% of the present, then the discount rate would be 1.0/0.9 or 11.1%.

Inflation is real, such that today’s dollar is not worth yesterday’s dollar. It has two parts, the currency rate, and the product rate. The currency rate is the rate that has to be applied to the medium of exchange. For example, the medium of exchange in most transactions in this county is the US dollar. A dollar in 2023 is not worth as a much as a dollar in 1960. A currency can be commodity-based or fiat‑based. If it is commodity-based, then there is the possibility that economic transitions can not take place because a group has too much of that commodity and does not want to participate in economic transactions. The best currency, medium of exchange, should allow all economic transactions to take place. The US has been not been on the gold standard, a commodity-based currency, since since the 1930s and is a fiat-based currency where the dollar is tied to the US economy. If the economy grows, then more dollars need to be printed.

Neither the discount rate nor the currency rate is random. However, the product rate IS random. Like other random phenomena, such as the weather, we can talk about it but can do very little about it.  The product rate is governed by such things as consumer preference, supply chain disruptions, the weather, and other random events.

The interest rate has to at least cover the discount rate, otherwise there is no sense in investing in the future. The currency rate should be as close to zero as possible. The product rate is a random number. The sum of the currency rate and the product rate should be kept below the discount rate or investment in the future will not make sense. Therefore, there is a reason that we should worry about inflation, but we have to expect that inflation can be greater than zero.

The Federal Reserve Bank is principally charged with maintaining the currency rate, but it is also expected to maintain the total interest rate. This does not mean that it has control over total inflation because it can NOT control random events. But by setting the prime rate, the rate of inter-bank loans, which is in keeping with the Federal Reserve Bank's role as the lender of last resort, it can have an influence on interest, and thus appear to have an impact on inflation. If other lenders set the interest rate as the prime, the Federal Reserve Bank's inter-bank loan rate, plus a rate, and that interest rate should be less than the discount rate minus the product rate, then the illusion is that by setting the prime rate the “Fed” is controlling product inflation when in fact it is only time shifting demand and supply between the present and the future.