Federal Reserve, money supply, and debt
Okay, let me get this straight, maybe...
The Federal Reserve controls the money supply by lending money to banks. If it wants to expand the money supply, it lowers the interest rate changed, and if it wants to shrink the money supply, it raises the interest rate.
Inflation can be controlled by shrinking the money available for loans. By converse, deflation is controlled by increasing the available money?
I imagine the Federal Reserve has no actual "reserve" - no actual resources like gold to back up its lent money.
I suppose the federal reserve only loans moneys to big banks and that they are always "good" for repaying the money. Big banks take in savings from clients AND borrow from the federal reserve to have money available to loan. THUS client savings can be much less than client borrowings.
If the economy keeps expanding, like flying a kite, the federal reserve can keep unrolling more string (loans) to keep the economy in balance.
When they recently lowered the interest rate as low as 0.5%, while 2003 CPI increased 1.9% and 2004 CPI increased 3.0%, effectively the Federal reserve was charging a negative net interest. That is if they loaned out $1000 for 1 year, they'd only get back say $1005, while inflation would make the effective value down by 3% - say to ~$972. Of course they don't need to make money I guess.
The same logic might apply with deflation. That is, if deflation rate was 3%, the federal reserve might loan money as -5.5% interest. There's no mathematical difference. In both cases, the fed rate was 2.5% below CPI rate.
It is a funny idea. I loan you $1000, and for the privlege of being able to loan you money, I offer $55/year to YOU to encourage you to keep my money longer. Something is terribly crazy here.
Maybe not. If there's real DEFLATION, that means WEALTH is decreasing in value. Holding a deflating asset is unattractive, so I guess I do have to keep giving you payments to encourage you to keep the deflating asset.
I wish I was a little smarter - or that someone could explain all this simply. It seems simple on the surface, but the dynamics of feedback effects seem to be harder to see and what's really important.
Anyway, the federal reserve is now carefully increasing its loaning rate. That means banks have an incentive to repay money they've borrowed, and that means they have less money to loan out. Because there's less money to loan out, and the money that is available has a higher interest rate, less people borrow money, and those with debt (and variable interest rates) have an incentive to repay it. Something like that - ignoring inflation at least.
Some people have been saying there is a housing value bubble. When interest rates were low, people could afford to buy more expensive homes. However when interest rates go up less people will be able afford new mortgages, and those selling will have less buyers, and they'll have to reduce prices to sell, and that could cause deflating prices. Similarly economic downturn where more people need to sell because of unaffordable homes, again, there'll be too few buyers for good prices. Such people might need to sell at a loss - even below their mortgage balance to get a sale. Obviously mortgage lenders want 20% down to get avoid this danger - and charge mortgage insurance otherwise.
Overall it would seem to me to be more "risky" for mortgage lenders. 30 year fixed rate mortgages seems insanely optimistic. If you set a rate that is too high people won't take your offer. If you set too low, inflation can eat all your profits.
As much as having a 5-year ARM Mortgage (4.75% for 60 months, 2.25% above U.S. security rate after that) seems scary, it offers the right incentives to me - to make extra payments early and often. I suppose many people get them because they figure they'll move in 5 years anyway, and its true - such people are better off with a lower rate now than a rate set on a 30 year gamble that won't happen.
Having the ARM saves me about $2000/year on interest for 5 years, or $10,000 "ahead" I'll be after 5 years. With luck I'll have 60% equity by then, and even at 10.5% maximum rate, I'm ahead for 2 years. So it's a gamble - fair enough. If I was loaning money long term, even with no desire for profit, I'd say "inflation+1%" and feel justified for that.
Later!
The Federal Reserve controls the money supply by lending money to banks. If it wants to expand the money supply, it lowers the interest rate changed, and if it wants to shrink the money supply, it raises the interest rate.
Inflation can be controlled by shrinking the money available for loans. By converse, deflation is controlled by increasing the available money?
I imagine the Federal Reserve has no actual "reserve" - no actual resources like gold to back up its lent money.
I suppose the federal reserve only loans moneys to big banks and that they are always "good" for repaying the money. Big banks take in savings from clients AND borrow from the federal reserve to have money available to loan. THUS client savings can be much less than client borrowings.
If the economy keeps expanding, like flying a kite, the federal reserve can keep unrolling more string (loans) to keep the economy in balance.
When they recently lowered the interest rate as low as 0.5%, while 2003 CPI increased 1.9% and 2004 CPI increased 3.0%, effectively the Federal reserve was charging a negative net interest. That is if they loaned out $1000 for 1 year, they'd only get back say $1005, while inflation would make the effective value down by 3% - say to ~$972. Of course they don't need to make money I guess.
The same logic might apply with deflation. That is, if deflation rate was 3%, the federal reserve might loan money as -5.5% interest. There's no mathematical difference. In both cases, the fed rate was 2.5% below CPI rate.
It is a funny idea. I loan you $1000, and for the privlege of being able to loan you money, I offer $55/year to YOU to encourage you to keep my money longer. Something is terribly crazy here.
Maybe not. If there's real DEFLATION, that means WEALTH is decreasing in value. Holding a deflating asset is unattractive, so I guess I do have to keep giving you payments to encourage you to keep the deflating asset.
I wish I was a little smarter - or that someone could explain all this simply. It seems simple on the surface, but the dynamics of feedback effects seem to be harder to see and what's really important.
Anyway, the federal reserve is now carefully increasing its loaning rate. That means banks have an incentive to repay money they've borrowed, and that means they have less money to loan out. Because there's less money to loan out, and the money that is available has a higher interest rate, less people borrow money, and those with debt (and variable interest rates) have an incentive to repay it. Something like that - ignoring inflation at least.
Some people have been saying there is a housing value bubble. When interest rates were low, people could afford to buy more expensive homes. However when interest rates go up less people will be able afford new mortgages, and those selling will have less buyers, and they'll have to reduce prices to sell, and that could cause deflating prices. Similarly economic downturn where more people need to sell because of unaffordable homes, again, there'll be too few buyers for good prices. Such people might need to sell at a loss - even below their mortgage balance to get a sale. Obviously mortgage lenders want 20% down to get avoid this danger - and charge mortgage insurance otherwise.
Overall it would seem to me to be more "risky" for mortgage lenders. 30 year fixed rate mortgages seems insanely optimistic. If you set a rate that is too high people won't take your offer. If you set too low, inflation can eat all your profits.
As much as having a 5-year ARM Mortgage (4.75% for 60 months, 2.25% above U.S. security rate after that) seems scary, it offers the right incentives to me - to make extra payments early and often. I suppose many people get them because they figure they'll move in 5 years anyway, and its true - such people are better off with a lower rate now than a rate set on a 30 year gamble that won't happen.
Having the ARM saves me about $2000/year on interest for 5 years, or $10,000 "ahead" I'll be after 5 years. With luck I'll have 60% equity by then, and even at 10.5% maximum rate, I'm ahead for 2 years. So it's a gamble - fair enough. If I was loaning money long term, even with no desire for profit, I'd say "inflation+1%" and feel justified for that.
Later!
posted by Ares Olympus at 2:35 PM
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