After closing at 0.54 percent in July 2020, the yield on the 10-year US Treasury Bond settled at 4.57 percent in December 2024. Some commentators believe that the massive increase in yields is because of a strong increase in inflationary expectations.
Many assume that whenever the central bank raises the growth-rate of the money supply through the buying of financial assets such as Treasuries this pushes the prices of Treasuries higher and their yields lower. This is labeled as the “monetary liquidity effect.” This effect is inversely correlated with interest rates. Furthermore, an inflationary increase in the money supply, after a time lag, strengthens economic activity, and this pushes interest rates higher. Note that we have here a positive correlation between economic activity and interest rates.
After a much longer time lag, the increase in the growth-rate of money supply begins to exert an upward pressure on the prices of goods and services. Once prices begin to move higher, the inflation expectations effect emerges. Consequently, this starts to exert a further upward pressure on the market interest rates.
Hence, by popular thinking, liquidity, economic activity, and inflation expectations are seen as key factors in the interest rate determination process. Again, this process is set by the central bank’s monetary policies, which influences monetary liquidity. The monetary liquidity effect, in turn, gives rise to two other effects. This way of thinking originates from the writings of Milton Friedman.
The popular theory of the interest rate is not established from a theoretical framework that “stands on its own feet,” but derived from empirical observations. In this sense, theories of the interest rate do not explain, but only describe. Furthermore, such a theory will not be able to explain the formation of the interest rates in the absence of the central bank.
Time Preference and Interest Rates
Individuals must necessarily give attention to maintaining their lives—basic needs—before consideration of more distant wants. Time is always a consideration in human action. According to Carl Menger,
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period.
This means that an individual assigns higher value to present goods over future goods, to present satisfaction over future satisfaction. For example, consider a case where an individual has just enough consumer goods to keep himself alive. This individual is unlikely to save those goods for later, let alone invest or lend his paltry means. The cost of doing so would be too high, and might even cost him his life.
Once the individual’s consumption goods start to expand, the costs of saving, investing, or lending starts to diminish. Allocating some of his goods towards saving, investment, and lending requires a sacrifice in the present. In order to invest, goods must first be produced and saved. In terms of capital investment of the lengthening of the period of production, there must be enough saved resources to sustain one or more individuals throughout the period. This saving enables the development of tools and machinery that, if successful, can contribute to greater productivity, efficiency, and enable further saving and investment.
From this we can infer that, by restricting present consumption, individuals save in order to have more goods for the future, which can either be consumed later or invested. Furthermore, increased saving lowers the premium of the present consumption versus the future consumption (i.e., to the decline in the interest rate). Conversely, factors that undermine the expansion of saving are likely to increase the premium of the present consumption versus the future consumption (i.e., to the increase in the interest rate, all other things being equal).
According to many popular views, changes in economic activity are positively associated with interest rates. However, if the increase in economic activity is because of the expansion of savings, this produces a decline in the time preferences, and thus to the lowering of interest rates and not an increase, as the popular framework suggests.
Interest Rates and Inflation
When money is artificially inflated “out of thin air” and injected into the economy, this sets in motion an exchange of nothing for something. The earlier receivers of the recently-injected money can now divert to themselves consumer goods from the producers of these goods. In similarity to the counterfeiter, the printers and receivers of the inflated money can now increase the purchases of various assets, thus pushing their prices higher and their yields lower.
This also has the consequence of artificially lowering the interest rate, misleading entrepreneurs about the seeming profitability of certain long-term projects. Genuine growth can also take place alongside artificial growth, but the inflation has distorted the price and production structure, leading to a boom-bust cycle. However, once genuine savings start to decline, and since inflation cannot continue forever, time preferences and, consequently, the market interest rate is going to increase. This will reveal the unsound long-term projects and investments, leading to the bust of the boom-bust cycle.
A situation could emerge where the central bank attempts to counter a rising interest rate trend by means of injecting monetary “liquidity” (i.e., inflated money and credit). This will ultimately make the situation worse. This is because the increase in the monetary liquidity sets in motion an exchange of nothing for something, thereby ultimately weakening production and economic stability.
We can expect an oscillation of the market interest rates along the rising trend. The oscillation emerges because the central bank, by pushing the monetary “liquidity,” temporarily lowers the market interest rates. However, the decline of genuine saving and the limits of inflationary policy pushes the interest rates upward, hence the oscillation of the market interest rates along the rising trend. In a free market, interest rates correspond to individual time preferences. Whenever individuals lower their time preferences, this means that they are signaling businesses to arrange a suitable capital structure in order to be ready for the increase in the demand for the consumer goods in the future.
We suggest that a steep increase in long-term interest rates since July 2020 is likely in response to the sharp decline in the pool of savings brought about by reckless government and Fed policies. The fact that individuals pursue conscious, purposeful actions implies that causes in the world of economics emanate from individuals, not from various factors. Every individual assesses changes in various factors against his goals.
It follows that neither monetary “liquidity,” nor economic activity, nor inflation expectations are the essence of what determines interest rates. It is individual decisions regarding present consumption versus future consumption that is the key determinant of interest rates. Monetary policies only distort interest rate signals, thereby leading to a misallocation of resources, which leads to the boom-bust cycles.
Conclusion
The strong increase in the long-term yields on US Treasuries most likely mirrors a steep increase in individual time preferences. A key factor behind this increase is reckless Fed and government monetary policies that have severely damaged the process of savings formation. Contrary to mainstream thought, market interest rates are determined by changes in monetary “liquidity,” economic activity, and inflationary expectations. In this framework, the causes originate from various factors, not from individuals. It depicts individuals like robots that mechanistically react to monetary “liquidity,” economic activity, and inflationary expectations. We conclude that individuals’ conscious and purposeful action regarding present consumption versus future consumption is the key determinant of interest rates.
