If asked who sets interest rates in for the economy, most of us would answer that the Federal Reserve (the Fed) does. In other words, a government-created central authority “sets” interest rates. If those who were asked had some background in economics, they might say that, to be more accurate, the Fed sets some baseline interest rates. This includes the Federal Funds Rate (the rate at which banks can lend to each other) or the discount rate (the rate at which banks can borrow from the Fed) that have a powerful influence on most other interest rates and certainly move those interest rates in one direction or another. Wikipedia actually has a good description of this.
On the other hand, if we were asked about the establishment of the price of food, computers, gasoline or televisions, most of us would say they are set in the marketplace by forces of supply and demand. And if someone asked why we don’t have an equivalent of a Fed to set prices for food, computers, gasoline or televisions, those who have studied any economics would readily recognize that government determination of prices (or even deliberate manipulation of prices) distorts market outcomes. Depending on the nature of price manipulation, they can cause shortages and surpluses. Rent control can cause blighted housing. And in the labor markets, minimum wage laws cause unemployment. Centralized price manipulation will necessarily shift investments and production decisions from areas that are most consistent with consumer desires to areas that the market would not support otherwise. Simply look at what happened to oil and gasoline in the 1970s, markets across the board during the era of Nixon’s economy-wide price freeze, or what is currently happening in Venezuela to see the distortive effects of government determination of prices of goods and services generally.
Clearly, economists recognize that the most efficient way for prices to be determined is through the free interplay of buyers and sellers making decisions based on their own preferences. Neither the head of a central pricing board or the president of the country can know what these prices ought to be. And yet, when it comes to the price that we call the interest rate, both a central pricing board and the president think they know precisely what the right price is, and seem to be in complete disagreement about it.
The president complains that the Fed’s interest rate is too high. In fact, he suggested that the Fed should set the price at zero. On the other hand, the Fed is constantly “fine-tuning” the rates to what they believe is correct. But the fact is that unless they are omniscient beings, neither the president nor the Fed has or even can have a clue about what interest rates should be. In fact, if they could obtain the information necessary to set the right interest rate, they could likewise obtain the information needed to set the right price of any good or service in the economy. Markets would be unnecessary, and socialism would be completely obtainable.
From an economics perspective, what is the function of interest rates? In a free-market, interest rates are the price for loanable funds and are determined by the interaction of the supply of funds available for lending and the demand for those funds by borrowers. The supply of loanable funds is the amount that people are willing to save at different interest rates, and the demand is determined by the amount people would be willing to borrow at different rates. Like in other markets, the prices (in this case the interest rates) are determined by the interaction of these two components.
But, of course, this leads to the question of what determines supply and demand. In economist jargon, it is what is called time preference, that is, people’s preferences for wanting to make purchases further into the future relative to the near term. So, the more people who are focused on the future—making a down payment on a house, saving for their children’s education, or preparing their own retirement—the more they will want to save at any given interest rate. Demand for loanable funds comes from anxiousness to make near term purchases on consumer goods like TVs and computers but also from entrepreneurs and business people, small and large, looking to start-up or expand operations. People looking to borrow money will be willing to borrow more at lower interest rates than at higher rates. Suppliers of loanable funds will be willing to supply, i.e., save more, the higher the rates and less at lower interest rates. It is the interplay of these forces that, in a free market, will determine the actual market interest rates, unless, of course, the market interest rate is subject to Fed manipulation.
Freely determined interest rates perform an important role in coordinating people’s plans. When people are saving more, it means that they want to purchase more goods and services in the relatively distant future. This increased savings reduces interest rates, which makes borrowing on the part of entrepreneurs and businesses cheaper. What this means is that it makes longer-term investments, that is, investments that will produce goods and services further into the future more profitable and more future goods will be produced. The interest rate is performing the important function of coordinating the preferences of consumers with the plans of producers through time. It is part of the marvel of how free markets work and create orderly production decisions that are consistent with people’s preferences.
From the perspective of the market, represented by this analysis, the Fed’s determination of interest rates is not only arbitrary but disruptive. Rates that are not reflective of people’s time preference, i.e., people’s preferences for the present as compared to future goods, will drive a wedge between the desires of savers and entrepreneurs and investors. This is the case with Fed determined rates, as no central authority has any way of knowing what people’s savings plans or business’ borrowing/investment plans are. If the Fed sets rates that are below that which would be determined by real savers and borrowers, then investments will be made in goods that consumers have no intention of buying. There will be overproduction relative to planned for consumer purchases. On the other hand, if the Fed sets the rates higher than what would have arisen from real market forces, there will be underproduction. In 1974 Austrian school economist Frederick Hayek won the Nobel prize for his explanation of how the boom and bust business cycle is caused by these Fed-driven mismatches in the market for loanable funds.
The Federal Reserve should pull out of the interest rate manipulation business completely. Having a Fed whose main job, at least in the eyes of the public, is to set or move interest rates in centrally determined directions makes no more sense than having a powerful government agency determining what should be happening with any other price in the economy. If the Fed could know the right price for loanable funds, then there is no reason to think that they couldn’t also know the correct price for shoes, computers, or food. It is the fact that neither the Fed nor any other central authority can know the right price for any of these products, interest rates included, which makes efficient socialist central planning impossible.