China Does Not Determine U.S. Interest Rates
Most experts hold that China's reluctance to allow its currency the Yuan to appreciate against the US dollar is the key factor behind the low interest rate structure in the US. This is incorrect, for reasons I explain below. It is important to understand the causal factors now, before the US falls back into recession and China, rather than the Federal Reserve, catches the blame.
The Chinese currency is pegged to the US dollar at 8.276 Yuan. Given China's growing trade surplus with the US, most experts are of the view that sooner or later the Yuan will have to appreciate and this in turn will push the US interest rate structure higher. In March, the seasonally adjusted trade surplus with the US stood at $9.3 billion against $8.5 billion in February and $6 billion in March last year.
To prevent upward pressure on the Yuan, it is held, Chinese authorities are buying all the US dollars earned through exports and capital inflows and investing them in US Treasury securities. In short, China's demand for US Treasuries keeps their prices high and yields low.
In March, China's holdings of Treasuries stood at $223.5 billion against $224.9 billion in February and $158 billion in March last year. Consequently, on account of relatively low yields on Treasuries, the mortgage rate is much lower than it would have been if not for Chinese buying, or so it held.
For instance, in April the rate on the 30-year conventional mortgage stood at 5.86% against 5.93% in March. As a result of the relatively low level of the mortgage rate, the housing market and general economic activity remain buoyant (see chart).
Following this logic, if China were to cut its support for the US dollar and let the Yuan appreciate this would push US interests rate up. This in turn would burst the US housing bubble and push the economy into recession. It seems therefore that China is the key factor behind the interest rate levels in the US and the future course of the US economy.1
The essence of interest rate determination
The essence of the phenomenon of interest is the cost that the saver endures. This cost stems from the fact that the saver has given up some benefits at present. For instance, when John exchanges his $10 for Robert's promise to repay this sum in one year's time John in fact gives up his claims on final goods and services for $10. This means that he gives up various benefits that he could secure. For sake of simplicity let us assume that the value of benefits according to John's personal evaluation in accordance to his set-up is worth $11. (Note that the principal of exchange implies that individuals exchange things they have for things they prefer more. Hence, for John to agree to exchange his current $10 for goods he must value the goods at more than $10). Hence, the cost that John incurs by giving up his access to goods and services at present is the opportunity to gain 10%.
The fact that the saved dollar incurs a cost to the saver means that the same dollar that is employed to secure goods and services at present carries a premium over the saved dollar. In other words, by saving and therefore by not employing the $10 in an exchange for present goods and services the saver gives up the opportunity to gain the 10%. Hence the present dollar is at a premium over the saved dollar. Consequently, an individual will undertake saving only if the return on the saved dollar will be in excess of the cost of saving. In our case, John will agree to lend his $10 for a return above 10%. The return above 10% implies that the perceived benefits from future consumption are expected to surpass the benefits from present consumption. According to Mises,
The postponement of an act of consumption means that the individual prefers the satisfaction which later consumption will provide to the satisfaction which immediate consumption could provide.2
By assigning a higher valuation to the present dollar versus the future dollar on account of the cost incurred by the act of saving an individual therefore expresses a positive time preference. Now whilst John is ready to lend his savings for a return of above 10% he must find a borrower that is ready to pay more than 10% for having $10 for one year. Robert the borrower finds it advantageous to be a borrower. Why? — because his personal set-up dictates so. In other words his cost of saving $10 is way above the 10%. Let us assume that the cost is 15%. Obviously if he can obtain funds for less than 15% he will be a borrower. At an interest rate above 15% he will become a lender. The interest rate therefore will be set in the range of 10% to 15%. For the sake of simplicity let us now assume that the agreed rate is 12%. At this rate both the lender and the borrower derive personal gain.
Now, what will happen to interest rates with an expansion in real wealth? With all other things being equal the cost of savings will fall and a lowering of interest rates will ensue. Why is that so? Because with less wealth various real goods carry much greater importance as far as life and well being is concerned. But as the pool of real wealth expands people can now undertake various lower yielding investment projects since the opportunity cost in terms of their sacrifice is now much lower than before. This stems from the fact that the first unit of real wealth serves to support the most important requirements as far as life and well being are concerned. The second unit of real wealth serves to support the second most important requirements, etc.
Observe that the driving force of interest rate determination is individual's time preferences. However, the realization of time preferences in terms of interest rates requires the existence of money. In other words, in the market economy the implementation of time preferences takes place via the monetary channel.
Let us now examine how changes in time preferences interact with money and culminate in market interest rates. The lowering of time preferences on account of real wealth expansion will become manifest in a greater eagerness to lend money and thus the lowering of the demand for money. This means that for a given stock of money there will be an increase in the excess supply of money. To get rid of the excess people will start buying various assets and in the process will raise their prices and lower their yields. In short, the increase in the pool of real wealth will be associated with a lowering in the interest rate structure. The converse will take place with a fall in real wealth.
What will happen to interest rates on account of an increase in money supply? An increase in the supply of money, all other things being equal, means that those individuals whose money has increased are now much wealthier. This in turn lowers their cost of savings and sets in motion a lowering in time preferences. Hence, this sets in motion a greater willingness to invest and to lend real savings. The increase in lending and investment means the lowering of the demand for money by the lender and by the investor. Subsequently an increase in the supply of money coupled with a fall in the demand for money raises the excess supply of money, which in turn bids the prices of assets higher and lowers their yields.
We can thus see that the key for the determination of interest rates is individuals' time preferences, which are realized through the supply and demand for money or by excess money. An increase in excess money leads to downward pressure on interest rates while a fall in excess money leads to upward pressure on rates.
What effect does China have on US interest rates?
Let us now examine the role of China in this framework. As far as the supply of money, i.e. the supply of US dollars, is concerned, China has no effect whatsoever. The sources for the supply of dollars are the Fed and fractional reserve banking.
Also, China's exchange rate policy has very little effect if at all on changes in the demand for US dollars as such. Thus, when China raises exports of goods to the US the first effect of this is to raise China's demand for the US dollar. However, once the Chinese central bank invests all these dollars in US Treasuries this in fact lowers Chinese demand for US money. Hence the overall effect is no change in demand. This means that for a given supply of money the amount of excess US money remains unchanged overall—implying no effect on US interest rates.
Now, if China were to decide to sell off its holdings of US t-bonds, obviously it would lead to an initial rise in yields. However, the Chinese are unlikely to sit on the dollars—they most likely will employ the dollars obtained from t-bond sales to purchase some other US assets, which in turn will push their prices up and lower their yields. In other words China's action will not have any effect on excess US money overall. Hence over time China's selling off of t-bonds will have no effect on interest rates.
After falling to 5.23% in June 2003, the mortgage rate in fact has been in a mild up-trend. It stood at 5.86% in April this year (see chart). A major factor behind this up-trend is the downtrend in the growth momentum of excess money AMS since early 2003.
It is this downtrend in the growth momentum of excess money that poses a threat to the housing bubble and to various economic activities that sprang up on the back of the previous up-trend in the excess money growth momentum. However, the key factor that determines the rate of growth of excess money is the monetary policy of the Fed and not China's exchange rate policy.
We can thus conclude that the key-determining factor in the setting of US interest rates is the amount of US excess money supply. Over time this excess is predominantly driven by the supply of money, which is set in motion by the Fed's monetary policies. In this respect the Chinese factor is completely irrelevant as far as US interest rate determination is concerned. So if the economy were to fall into a recession on account of a bursting of the housing bubble we should blame the Fed for that and not falsely point the finger at China.
Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. Send him MAIL and see his outstanding Mises.org Daily Articles Archive. Comment on this article on the Mises Economics Blog.