Tuesday, 21 September 2010

The Fed, Idle Ships and Interest Rates

Today, the yield on the 2-year Treasury note hit the all time low of 46 basis points, or less than .5%

Traders talk about the bond bubble (it has a nice ring to it), quantitative easing (QE) or QE2 (the second round of QE. Got it?) They opine how bonds have become attractive in the absence of other investment alternatives, which is why their price is higher and their yield lower. (Never mind the contradiction in bonds becoming attractive while their yields are pushed lower.)

All that talk comes from the illusion that interest rate is a “thing” that the Federal Reserve sets – and everyone follows.

Nothing could be further from the truth.

Interest is the claim of finance capital on the industrial capital. It is a deduction from the profit, set through negotiation and supply and demand.

When profit opportunities are destroyed and capital cannot be profitably employed, it must sit idle, either in the form of unusable cash on corporate balance sheets or, more symbolically, in the form of idle ships.

Idle industrial capital cannot pay interest. In fact, it would have no reason to borrow. Hence the fall in the demand for loan capital and the subsequent fall in interest rates.

The Fed does not “set” interest rates. Rather, it takes note of, and acknowledges the prevailing market winds and adjusts the sails of the state ship accordingly.