Rate Disparity Book

Rate Disparity

The dilemma of setting interest rates in modern money systems

What must be understood about raising interest rates, is that central banks raise interest on themselves. The rate setting is what a country's own treasury must pay on savings and the national debt.

The practice of using interest rates to manage the price level goes back to the gold standard.

Yield Curves

Yield curves reflect two different kinds of information.

1. The anticipation of future interest rate settings
2. The premium for longer term securities

Note that even future dated securities may trade very actively, and thus be considered highly "liquid"

Temporal Exchange Rates

Interest serves as an exchange rate between money now and money later. This is not simply an expression of time preference, as a debt to pay money, can potentially circulate in markets themselves. As we describe with treasury bonds, they can almost be viewed as

A temporal exchange rate allows for two things:

1. For traders to speculate on real rates.
2. To devalue the currency in relative terms by offering a yield.

== The nominal yield sets

By a yield curve, I am referring specifically to term premiums, and not simply speculation on the path of interest rates.

A yield curve with no term premiums, simply becomes a flat line once the path of interest rates is taken into account.

The Ideal Unit of Account Has a Zero Discount Rate

In this sense, we are talking about the rate of discounting used for present value calculations(not the discount window rate). If there is a uniform discount rate possible for any size of principle, then it makes sense to simply use an asset with that yield as the standard unit of account.

Yields cannot be assumed to be uniform for widely variable principle amounts

In reality, yields are highly sensitive to the amount of your principle, and it is essentially financial malpractice to compare yields on multi-billion dollar projects, with yields on $10k being invested at a time. This is because both absolute and relative yields matter. An absolute yield is simply subtracting the final value of a portfolio from the value of the principle.

The need for more overhead on large projects and large portfolios, makes any direct comparison of yields unreasonable. This is also true of living organisms, larger organisms tend to grow more slowly and have a longer reproductive lifecycle period(doubling time).

Prices And Yields are Relative

Inherently, any yield is the relative devaluation of the currency or unit of account. If a bond yields 10%, that means a currency is depreciating 10%, compared to a bond.i

Bond Yield Targeting

Instead of using interest rates to try to control the change in value of a currency, it makes more sense to try to control the CPI adjusted yields of treasury bonds. This is best when allowed to float within a range.

While some experimentation may be needed to determine the best yield ranges, one could start with +3%/-2%. If inflation adjusted yields of tsy bonds drop below -2%, then rates can be increased. If these yields rise above 3%, then rates can be lowered.

For more persistent inflation(over 3-4 years), the range may need to be relaxed, with a larger potential upside or downside, for example, +5%/-3%,

Why Inflation Adjusting Instruments are Undesireable

Inflation adjusted financial assets have the same issue as fixed exchange or pegged currencies. Instead of graceful/gradual failure like equity, it makes the system unstable.

Adjusting rates upward to delay inflation, to stretch it out over a longer time frame, is a reasonable monetarist practice, however, as discussed, targeting inflation, instead of the real yield, also creates instability.

If the policy rate is elevated, then bonds can achieve a positive real yield, even with a high rate of inflation. For example, if the policy rate is 8%, and inflation is 7%, then bonds have a real yield of 1%, which could be considered acceptable. If inflation unexpectedly falls, then the real yield could be as high as 8%, with zero

inflation.

Duration: Mechanical Effects of Temporally Anchored Money

When you purchase a security, you are buying a temporal monetary anchor. It pays out a specific amount of money at a specific date.

Entities that don't issue Equity

Equity is a flexible, but costly financing tool. It is flexible in the sense that its value adjusts dynamically, and cannot create insolvency. It is costly in the sense that equity holders retain all the residual value, there is an unlimited upside for equity holders. While pro-active measures can help the different participants in a business to benefit comparably from business success, the design of equity makes the shareholder profit the lowest priority procedurally, but the highest priority in terms of decision making.

Equity benefits are paid out after all debts, which include wages and other obligations, thus in a procedural sense, equity claims have the lowest priority. But in term of governance and decision making, equity claims are treated as the highest priorities.

There are many financial entities that don't issue equity shares. For many of these, the reason is simply size and complexity.

Debt Valuation

Money without debt has no fundamental value or cost, so the price level is arbitrary.

But once you attach debt to money, then the price level determines the valuation of said debt.