The Price of Money

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Posted: Jun 10, 2014 12:01 AM
What makes interest rates move up and down? That's not a question for your Econ 101 final exam. It's a real-life issue that impacts the price you pay for credit -- for a mortgage, a student loan, a credit-card balance or a car loan. And these days, you'll get a lot of disagreement about where interest rates are headed, and why.

Interest is the price of money. The interest rate is the price a borrower pays to get money. A few basic things affect the price of anything in a free market: the availability of the commodity (money, in this case) and the credit-worthiness of the borrower (i.e., you wouldn't lend money to a deadbeat without exacting a very high price, a very high rate of interest).

Now, in a truly free market, the price of any commodity is impacted by supply and demand. Take corn, for example. Every year the farmers around the world plant a new crop of corn. (Corn is a global commodity, though dominated by the United States, which exports 20 percent of its crop.) The price of corn depends on how many acres are planted, and how the weather impacts the growing season. By harvest time in the fall, the markets have analyzed the size of the crop, and the world's corn users (ranging from corn flakes manufacturers to ethanol producers to animal and poultry feeders) determine how much they need to buy. Then the price is set in the futures markets, where buyers and sellers meet.

Pricing Money

The price of money is similarly set by global markets. In the global marketplace for money, the price is influenced by governments and central banks, which determine the amount of the money crop that will be created and the price of the money crop: interest rates.

Let's start with our domestic "crop" of money. Yes, the government helps create the annual supply of money through its power to borrow money by selling government IOUs -- Treasury bills, notes, and bonds -- adding to the stock of existing bonds it sold to borrow money in previous years.

When the Fed -- our central bank -- buys those bonds in the open market, it pays for them with newly created credit (money), which goes into the system, adding to the money supply. In recent years, the Fed has created literally trillions of dollars in "new money" to help the government borrow to finance its deficits. If there's plenty of money crop available, then interest rates can remain low -- at least for a while.

But unlike commodities such as corn and copper, a greater supply of money does not necessarily make its price go down. That's because -- eventually -- people will look at this huge supply of paper and wonder what it is really worth in buying power, if the government keeps creating more of it.

Think of Zimbabwe in recent years, where a $1 billion paper bank note bought only a loaf of bread! The technical name for this kind of destruction of confidence in the paper currency is inflation. Despite all the money created in the United States in recent years by the Fed, we don't have any signs of inflation, yet. The U.S. dollar is still in great demand around the world.

The Global Money Market

While corn and copper are the same commodities around the world, each country or region has its own money. Market participants can choose the currency they want to hold. They will naturally want to hold the currency of a "strong" country -- one that is not being devalued by inflation, and where they can use that currency to invest in important assets, such as stocks or businesses that are growing and may yield profits.

Here's the shocker: Despite all the money the Fed has created in recent years, the U.S. dollar is currently the strongest, most desirable currency in the world! That means the U.S. can borrow at relatively low interest rates to finance its budget deficits.

That surge of money coming into the U.S. from around the world is helping push the stock market to new highs, helping finance businesses at low interest rates, and helping to create growth here in America.

Why are America and the U.S. dollar so attractive? Well, look at the alternatives. Japan has announced it will print a lot more money to get its economy going by weakening the value of its currency (the yen), thereby making its exports "cheaper" to the rest of the world. Now Europe has climbed on the same money creation bandwagon, to get the Euroland economies (think Spain, Portugal, Italy) growing and exporting again. China already has policy of cheapening its currency, the Renminbi, which has fallen by about 3 percent over the past year -- enough to make China's exports more attractive to foreigners, thus stimulating production in its factories.

How do these regions devalue their currencies, making them cheaper? The governments or central banks do it by buying U.S. dollars, and then selling their own currencies. And a lower currency value makes their exports more attractive.

And so, despite our own low rates, the dollar remains relatively attractive -- enough to bring money here, and attract money to buy our Treasury notes. So the U.S. government can sell IOUs at very low rates. That huge demand for our IOUs has brought interest rates down to incredibly low levels -- about 2.5 percent for a 10-year Treasury, upon which mortgage rates are based.

The supply of Treasuries is moving lower, as well. Our federal budget deficit is expected to be the lowest in 8 years this year -- only about $492 billion. So despite the Fed's plan to buy fewer bonds, foreign central banks are taking up the slack. In addition, U.S. banks are holding more Treasuries as regulators demand higher "capital" holdings in an attempt to make banks safer.

All that demand for U.S. dollars and debt, along with a slowing supply of new money, means the United States doesn't have to offer higher interest rates to attract money. In fact, money is coming here despite falling interest rates.

How long can this situation continue? That is the quadrillion dollar question being debated in markets around the world. Most of the experts are shocked that the dollar remains strong and U.S. interest rates remain low, despite our huge budget deficits and relatively slow economic growth.

While this situation hurts American savers, who earn little interest in their bank accounts, it helps borrowers who can lock in long-term mortgage loans at low rates. Yet many potential borrowers are fearful about their jobs and business prospects -- and afraid to take on even those low-rate loans. They may look back one day in the future, when rates are much higher, and kick themselves for missing out on an opportunity. And that's The Savage Truth.

Terry Savage is a registered investment adviser and is on the board of the Chicago Mercantile Exchange. She appears weekly on WMAQ-Channel 5's 4:30 p.m. newscast, and can be reached at www.terrysavage.com. She is the author of the new book, "The New Savage Number: How Much Money Do You Really Need to Retire?" "Terry answers readers' personal finance questions on her blog at www.TerrySavage.com. To find out more about Terry Savage and read her past columns, visit the Creators Syndicate Web page at www.creators.com.

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