Hola! I’m writing you today from gorgeous Cafayate, Argentina, where I have just spent a week enjoying the beauty of La Estancia de Cafayate, the warmth of the Argentine gente, the graciousness of Doug Casey and David Galland, and the wonderful company of our fellow La Estancia de Cafayate homeowners…some of the most productive, fascinating, entrepreneurial, and downright helpful and awesome people I’ve ever had the pleasure to know.
If you are in the market for internationalizing some of your assets (or for simply enjoying the pleasure of an outstanding group of people!) I *highly* recommend you visit La Estancia. True to his word as always, Doug continues to under-promise and over-deliver—the newly completed health club, spa, and pool are absolutely stunning and rival any of the top fitness centers and spas of the world. Everything here is first class—from the gorgeous golf course and polo fields, to the beautiful and welcoming club house, to the many lovely homes already under construction, to the spectacular views and much more…it’s truly a lovely place.
Let’s jump into this week’s great questions!
First, Gilbert asks,
I’ve been reading a lot about this interest rates but I still don’t know how it works. My question is how does the government keep the rates “artificially” low? Who should really control the interest rates? the market? If the market should control the rates, how can it be controlled then? supply and demand? how can we know if the rate is “artificial” or not? I’m sure you can explain this in plain english as you did in fractional reserve banking….
i hope you can also make a blog about how to read financial statements of companies… i’ve been searching the web on how to read financial statement but it seems that my gut is telling me that they are not truly trustworthy…can you recommend a site or a reading material that can provide guidance on this dilemma of mine (i’m sure this is also a need for some of your readers).
i’m learning a lot from this blog & i’m always looking forward to reading it…let’s kick some bad ass….(“,)
Hi Gilbert! Great questions, as always! Let me see if I can tackle them today. First on interest rates…
At the most basic level, interest rates are a measure of risk. You may have heard them described as “the cost of money”, and that is accurate…if you want to borrow (or “buy”) $100 from someone, the interest rate is how much that $100 will cost you. This depends on you…if you are a credit-worthy person you will pay less to borrow that $100 than will someone who is less credit-worthy, because you are seen as a better risk.
You’ve seen this in car and home loans, and it works the same for countries as it does for individuals (hence why Greek bonds are at 20% and U.S. 10-year treasuries are at 2.25%…Greece is seen as a much bigger risk than the U.S.).
However, these interest rates are an inaccurate reflection of risk, because they are manipulated. In an ideal world, I do believe that interest rates should be set by the market (what the market will bear) and yes, via supply and demand.
But unfortunately we do not live in an ideal world…
Rather than allowing the market to determine the appropriate interest rates, the central banks of the world decide. It is not the government who manipulates interest rates; rather it is the central banks (and here in the U.S. that is the well-known Federal Reserve).
Historically, the Federal Reserve has attempted to “maintain a stable and growing economy through price stability and full employment”, its two legislated mandates, by manipulating short-term interest rates, engaging in permanent open market operations (POMO’s) and adjusting reserve requirements.
Let me define a few terms:
The Federal Funds Rate is the short-term interest rate at which U.S. depository institutions (commercial banks, savings and loan associations, credit unions, mutual savings banks, etc.) lend to each other overnight within the Federal Reserve system.
Banks try to stay as close to the reserve limit as possible without going under it, lending money back and forth to maintain a reserve level that is both legal and allows them to maximize profits (Heaven forbid they don’t maximize profits…).
The U.S. Federal Reserve sets a target for this Federal Funds Rate called the “Federal Funds Target Rate“, or FFTR.
This Federal Funds Target Rate is the U.S.’s most important and most influential benchmark interest rate. The interest rate is set by the Federal Open Market Committee (FOMC), and it uses this FFTR as its most potent tool for regulating the U.S. economy. It lowers the rate when the economy needs a boost (such as it does now…) and raises it when the rate of inflation is too high (such as in the 80’s under Paul Volcker when interest rates were upwards of 18%).
As our cardinal short-term interest rate, the FFTR influences some of the most important market interest rates throughout the world, including the LIBOR rates and the U.S. Prime Rate.
So how does the Fed manipulate this important short-term interest rate?
Well, the most common way it does this is by executing “POMO’s”, or “Permanent Open Market Operations”, which I wrote about here (these are the buying and selling of U.S. Treasuries and mortgage-backed securities).
When the Fed conducts a “POMO” and buys U.S. Treasury bonds, in essence it is creating artificial demand for those bonds…it is a “buyer” and causes the prices of those bonds to increase and the interest rates of those bonds to decrease, which they deem in our current economic situation to be “good” for our economy. In essence, this keeps interest rates on U.S. Treasury bonds low, which means it is easier for the U.S. to pay our debts. (Imagine if we had to pay the interest on our bonds that Greece is having to pay….we literally couldn’t pay it!)
I hope this makes sense…it is very complicated and definitely worthy of its own blog post. (Anything related to the Federal Reserve seems unnecessarily complicated, in my view!).
Regarding reading financial statements, I will write a post on that, too (I owe that to you—I haven’t forgotten!). I am searching for someone online who explains it *well*…I actually took a local college class from UC Berkeley on reading financial statements, and I found that extremely helpful. It was terrific having a person who could explain all of the intricacies to you, because it’s as important to understand what is “missing” or “hidden” in the financial statements as it is to understand what is there.
That’s it for today…I have several more great questions on the gold standard and inflation/deflation, and what a return to the gold standard might mean, but I am going to save those for next week as this is my last day in Argentina! I will write more on the interest rate manipulation, too…
Have a terrific weekend!
To your financial success,
—Kung Fu Girl