Introduction

Last week, I published on The Free Market Center Journal an article entitled “Price Determination and Interest Rates”. In addition, on May 6, 2024, I published “How to Calculate Interest Rates.” These two articles provide support and an introduction to this week’s article about “Why The Fed Cannot Change Interest Rates.”

This article has nothing to do with the power of The Fed or its influence on financial markets. I have watched The Federal Reserve implement “monetary policy” for over six decades. At one point The Fed attempted to influence the creation of money (by banks) to hit a target objection. Later, it shifted its objective to hitting target interest rates in the Fed Funds market.

For this paper, I care not whether The Fed ever achieved any of its target objectives. I want my readers to understand the calculation of interest rates and whether any entity can change any interest rate unilaterally. Erroneous thinking about the mechanics of any part of a system tends to reinforce erroneous thinking about other parts of the same system.

Many explanations of the monetary system begin with erroneous claims about the power of The Fed to “raise/lower” interest rates. I hope that if people see the error of their basic premise, they will examine the additional thinking derived from it.

Think, for example, of the numerous cries to “save our democracy” in a country that does not have a democracy.

I have provided the following diagram as a reference and reminder of the two parties required to establish an interest rate.

Interest – Time Preference

The idea of time preference provides the foundation for the concept of interest. Time preference simply means that goods and services in the present have a higher value to an individual than exactly the same good in the future.

To clearly comprehend time preference, you need to separate time preference from a cessation of wants. Time preference does not mean that people value things in the future less after satisfying their wants in the present. It means that the individual must choose between having the thing in the present OR having the same thing in the future.

Time preference holds true regardless of where the item falls on the current preference scale. For example, if a person prefers three cupcakes today over three bananas today, they would still value three bananas today more than three bananas in the future.

In summary, for an individual to trade a quantity of a good in the present for the same good in the future would require a larger quantity of the good in the future. We refer to the difference between the quantity in the present and the quantity in the future as interest.

I think you can already see that you need to know the present quantity and the future quantity to calculate the interest.

Importance of Relative Time

So far, I have referred to the “present” and “future” without specifying the time interval between now and the future. To determine the value of the good in the present and in the future, the parties must know the units of time that pass between now and the specified future. With the passage of each unit of time between now and the future, the value will decline in the minds of the parties.

In general, the further in the future, the lower the time preference—and thereby the value—for the good in the future.

Interest Rates

Real Interest Rates

We call the processes of all systems the “flow.” The accumulation of “flow” amounts to the “stock.” We state “stock” in terms of accumulated units of “flow.” “Flow” consists of the changes in “stock” over a specified unit of time.

In the classic stock-and-flow model of the bathtub, the stock might consist of 100 gallons of water. We might state the flow in gallons per hour, even if the water flows for only five minutes.

The strict definition of an interest rate consists of the units of flow per unit of time. For example, if a party lends $1Million and expects $1.3Million at the end of three years, the interest rate would amount to $1Thousand per year.

But, we don’t state interest in that manner.

Marginal Interest Rates

What people normally call the “interest rate” actually refers to the “marginal interest rate.” To calculate the marginal interest rate, divide the actual interest rate (e.g., $ 1,000 per year) by the original loan amount ($ 1 million) to arrive at 0.10 (or 10%) per year.

Marginal interest rates (AKA interest rates) provide a way to compare interest rates for different loan amounts over different periods of time.

Conclusion

I have made numerous comments on various online accounts clarifying the fact that no entity, including The Federal Reserve, can unilaterally raise or lower interest rates. From these comments, a person might get the impression that I have an obsession with calculating interest rates.

I might have an obsession of sorts with clear thinking. The calculation of interest rates provides only one of many examples in which the use of inexact language leads to flawed thinking. If you take just a moment, you will recognize that The Federal Reserve does not have the control that many attribute to it over interest rates, the money supply, employment, or “the economy.”

I believe firmly in the “principle of limited information.” This principle means you need to make sure you have enough information to make sound statements—no more but certainly not less.

Aretha Franklin has provided the best advice to people making affirmative statements: “Think.”