Prudent borrowers decide the rate of interest, and the general public decides the value of money
The interest rate of money is set by the borrowers-a central bank doesn't set them.
The producers of apples do not decide the price of apples-the people who buy apples decide their real price. Similarly, Walmart does not decide the price of goods it sells, it only makes offers to sell those goods at prices X, the final price being decided by the customers of Walmart. The same holds for interest rates of money-the borrowers decide the interest rate. Furthermore, the volume of sales of a product sold goes down as you increase its price-the same holds for interest rates. As you increase the interest rates, the number of borrowers who borrow goes down, or the volume of loans emitted goes down. See also this article on business margins vs. volume.
In any economic transaction not done under duress, the buyers decide the price of what they purchase; sellers only make offers. Therefore, when we talk about market price of objects, in reality we are saying that these are the prices which buyers pay for these objects. The interest rate of a loan is a price, and therefore the borrowers are the ones in reality who decide the interest rates of the loan; the lenders only making offers. The borrowers enter into a contract to pay back the loan with interest. The borrowers can choose not to borrow at all if they don't want to, or if they don't believe their cash flows and profits will cover the future interest and principal payments of the loan. Prudent borrowers will not borrow even at low interest rates if they cannot employ capital successfully to make sure that they can return the bank the principal and the interest without problems. Similarly, prudent lenders will not loan at high interest rates to parties who are at risk of default. The loan market is primarily decided by prudent borrowers and prudent lenders. Banks are a part of the lenders side of this market. Note that the Government is also a borrower in most cases; and has a major role to play in deciding interest rates of money, which is why market rates are indexed to Government rates.
Central banks, banks and the financial system in reality follows the market (or borrowers, as explained above) in setting rates. They can't set the price at which people borrow-but it does make sense for them to follow the market rates. When rates are low, as they are currently (2016), it means that the demand for loans in the market is low-and that's why the interbank rates, fed funds rate. etc. are low. Not the other way around. When the market has high interest rates-the Fed fund rates, etc. will all go up together with it, as they should. economics and finance types have this essential causality backwards. The exception is under market stress-when the Federal reserve does come in as a lender of last resort (covered below). But for most of the time, the functioning of the large lender-borrower market is what decides the loans banks charge for money.
You pay more interest rate to borrow if your profits (of stock) are higher, or you expect a good stable earnings from the job you hold, or you believe that the rents you get from your real estate holdings will be good (the three major groups of people in the economy). Banks, including central banks do not manufacture money out of thin air-they are always tied down by the deposits , the payments they are receiving from mortgages and other investments, etc. to decide if they can loan more money to other borrowers. When loaning out the money, the banks will also ask for a collateral or a guarantee-which is an onerous contract for borrowers. The banks do not give money out for free-what they sell is really a binding contract that the person or entity who takes out the loan will return the money in the future, together with some interest. Instead of sellers of money, it helps to think of banks as sellers of these very onerous contracts. The interest rate on the loan is decided by the prudent borrowers-people who think that they can employ the money usefully, and have no problem returning the principal with interest of what they will borrow. It is only the prudent borrowers who will get into the contract with the bank at fair terms-and they will not borrow if the interest rates are too high, or the contract terms are not clear, oppressive, etc. At least in places where there is no usury, i.e. definitely most developed countries, and also most developing countries as well, this is true.
The imprudent borrowers are as bad for the bank as they are for themselves. A bank who loans to imprudent borrowers goes down with such borrowers. This can happen sometimes (e.g. subprime loans in the US housing sector in 2007-2008), and the banks and financial institutions who indulge in such loans quickly meet their fate.
Note also that the US Federal Reserve has assets which are comparable to big private banks and investment firms like JP Morgan, Vanguard, Fidelity etc. (all in the order of a few trillion dollars, in 2017) Capital market managers (of stocks and bonds) taken together have much bigger assets than the US Federal Reserve. Private banks and investment firms are very instrumental in the corporate bond markets and loaning money to the US government- and thus are directly involved in "setting" interest rates. The IYI (Nassim Taleb's terminology-Intellectual Yet Idiot) Alan Greenspan, the retired Fed chief, may believe the Fed is everything-but the Federal Reserve is a rather small part of the financial sector (which is itself a small part of the economy).
Interest rates are low at certain times like right now (in Japan, USA and Europe, 2016) because prudent borrowers do not want to borrow, because they don't see good returns for their capital in the future. The same goes for workers who live by wages and people who live by rent. Even if a central bank or any other bank offers low rates of interest, if the people who want to take out the loan believe that they can't easily pay the interest AND the capital back, they will not take out the loan. The central bank and all banks follow the market-they lower rates in response to lower demands for loans, and increase them when market demand for loans is higher.
Even if you believe that a central bank could somehow lower rates, it doesn't follow that more loans will be emitted-because prudent buyers may feel that they can't even return the principal, let alone the interest, when they can't forecast their own returns or incomes well. In this sense money loans are very different from selling objects-while it is generally true that lowering the price of objects increase their demand, because money loans are a contract which runs into the future for the person who takes out the loan, and given that prudent buyers are the ones who are taking out loans, decreasing the interest rate does not necessarily increase its demand, because unlike an object who you pay for right away and are done with, this involves substantial commitment on part of the borrower into the future, and they risk ruin and bankruptcy if they can't pay back the loan (principal and interest). Money loans are far more burdensome to the borrowers than buying an object outright-and that's why the assumption that offering lower interest rates leads to an increase in the number (and amount) of loans is incorrect. Money loans are contracts with strict terms for the borrowers, and are not simple objects being bought and sold in the marketplace. Comparing money loans to objects and their prices is therefore not right. A money loan by a bank is not a gift; you still have to at least pay 100% of the the principal back (a 0% interest loan). However, someone can sometimes give you a gift of 1 kg of oranges, or for a very low price. I have never heard of a bank giving out money where it only wants 5% of it back (that would be the end of that central bank and the banking system supported by such a central bank).
I continue where Adam Smith left us in 1776-most money is borrowed by prudent borrowers, and most money is loaned by prudent lenders and banks, who, are careful about their own well being, the classic self-interest of Adam Smith. Therefore, speculators and risky borrowers are bad for the banks as much as they are bad for themselves (they will get ruined and will take the bank principal down with it). If the bank is giving loans to the wrong people, regardless of whether the loan is made at high or low interest rates, it will go under itself. The principal itself might not be returned.
Note that even in the 2008 crisis, it is the Government and taxpayers who bail out banks and financial institutions (AIG) and companies; the central bank doesn't, and can't. They are powerless. The real value of money is decided by the citizens of the country, and as long as they trust the Government, they will control the banking system, including the central bank. Powers attributed to central banks to bail out everyone etc. are imaginary. In the worst case, the Government will bail out a central bank, once again showing you that the real value of money is decided by the public, who choose to bail out a foolish central bank on their terms.
The central bank is an overseer over other banks. It is there to provide oversight so that banks do not engage in unscrupulous lending. This is done because a responsible government has a huge interest in a stable value of it's own currency. Note that the currency is more an instrument of the Government, and not of the bank; because the government directly depends on its value when it collects taxes. If bankers indulge in devaluing the currency by loans to irresponsible parties, they decrease the real buying power of the government as well; because the government collects taxes in domestic currency amounts. Any unfettered lending by the banks will reflect in a real loss of revenue in the government's tax collection. When I say real loss I mean the real buying power of that money, in what goods etc. it can acquire. The central bank and the banking system are dealing with an instrument whose faith is backed by the government; and that privilege comes with enormous responsibility.
A central bank also can't loan infinite amounts of money even to the government, even if it wanted to. For example, the maximum limit of money the US can borrow is set by the US congress. The government has many checks in place to keep several government agencies in balance with each other, so that there may be no abuse of power by one particular agency.
The jobless rate in the US, a silly number
Therse is a report published every month by BLS which is taken as the holy grail apparently for the Federal Reserve to measure unemployment rate. The report shows that 95 million Americans above the age of 15 are unemployed at any point in time (in the month) and not even looking for a job. In the around 150 million people who are unemployed at any time, there are another 95 million who are not (it is called participation rate)! This 95 million figure keeps changing too, and they publish that-it is 100 million sometimes, then 92 million, etc. etc. These are people taking temporary rest, out of job, working part time, traveling around, retiring, etc. etc. , plus the group is not the same people, it is a completely different set of people every 10 or 20 years. There is no reason to assume that there is a stable rate for this-i.e. Participation rate is not a constant, just another number thrown at the giant wall of data, and seeing what sticks. Most of the job report number fluctuations can be accounted for the flux between people who do not want to work for whatever reason, not because of interest rates, M2 money supply, etc. as the Federal Reserve wants you to believe. But the report ignores these details completely, because it has to come up with a nice number of around 5%...and obliges us with that. A large number of people do not want to have full time jobs in the US, and that is ignored by statistics experts like the BLS. The Fed in turn takes these numbers, and calling it data, talks about reducing it etc. Here's an article explaining the shortcomings of these report. and another one here. My point-the labor statistics are noise, joblessness is noise, and constantly changing, people don't work in a full time job for 5 years, then go back to work full time for 8 years, then go and travel and do nothing..all these things are not considered at all in the data! Garbage data put into a model of economy...
The biggest way to realize the bullshit data of the jobs report and unemployment rate is to think about the standard deviation of these numbers over time. A jobless rate of 2% to 10% is completely normal in my mind, it is the nature of things, and can't be attributed to one cause or another-knowing fully well that 37% of the adults call themselves unemployed at a particular time and we are okay with that! Any theory that a central bank can affect this highly variable "natural" rate of employment by changing interest rates, etc. is hogwash because you can never measure clearly if what you did by changing an interest rate lead to increased or decreased employment, it is all lost in very high standard deviation of the employment data.
Another big problem with the job reports is that it relies on surveys and then extrapolates. People lie in surveys, and there is no stable underlying distribution to think that surveys can be extrapolated. They may be statistically invalid procedures...two big ones this year (2016) when surveys got it wrong were that Britons wanted a Brexit and Americans wanted Trump to be president-survey data indicated that these things won't happen, but they did. This is a general problem with all surveys, as I have convered here.
GDP measurements are full of assumptions and approximations (data massaging), and the numbers are constantly revised. They also partly rely on surveys and questionnaires. Standard deviation of the data is not published. GDP growth numbers of 1% or 2% (positive or negative) are well within standard deviation and errors of data, and do not mean much.
GDP measurements indicate that the Japanese GDP has been stuck at the same value since 1990 (upto 2016). According to GDP publishers and people who believe in that number, Japan, a developed nation of 120 million people, has not advanced at all on the last 26 years. Instead of accepting that maybe the GDP data is not capturing the progress of that wonderful country, they keep insisting that Japan really has gone nowhere in 26 years.
Because the GDP measurement is itself an approximation, we should not place too much emphasis on growth and constant GDP increases, as seems to be in vogue today worldwide. The case of Japan discussed above shows this very clearly.
Interest rates, unemployment rate, GDP, etc. are some very imperfect numbers, and they must not affect public policy too much.
Central banks have no influence on inflation rates
Central banks claims of controlling inflation rates are even more questionable.
Normal inflation measurements are very noisy, and most of the massive data taking going on today on inflation with ever changing inflation baskets is nothing but noise. See more about this here.
Even if you believed that the published inflation number is real, good data, it is easy to show that this number has nothing to do with central bank interest rates. Here is a table showing present day (Feb 2018) inflation rates (year/year) to central bank rates, courtesy of Charlie Bilello (his twitter) at Pension Partners (see column 4 and column 5):
You can see that if central bank interest rates are high in a country, it doesn't mean that inflation is high - the relationship between the two is very weak.
If the US Federal reserve or the Bank of England were to raise interest rates they may end up where Brazil or Russia are (about 7% annual interest rate) but you can see that both those countries have inflation of about 2.5%. Inflation seems to remain in the system even after an increase in interest rates..I have no idea why the bankers at the US Fed reserve or Bank of England keep claiming that they are targeting inflation.
Argentine Central Bank in 2018 has set interest rates of 40%[annualized] (a ridiculous rate -an unreliable bank or government cannot attract more deposits by giving ridiculously higher rates to deposits; most people know that the banks here are straying away from your function of being a conduit between lenders and borrowers-the banks will never honor this promise of 40% rates) and the inflation keeps running high (more than 20%) anyway. By setting an interest rate of 40%, the Argentina Central bank is effectively saying to businesses that they should all just shut down their business and put their money in the Argentine banks; after all, any business would be more than happy to get 40% annual returns. Why work hard and try to make a living? Just put your money in the Argentine banks and watch yourself get rich. The Argentine Central bank is the biggest enemy of the Argentine peso. If rates were raised to something more reasonable (between 5% and 10%) the banking system would attract deposits. But not at 40%, where it reeks of mismanagement and fraud. This eventually shows up in the collapse of the Argentine peso vs the US dollar (and other major currencies).
The same is happening with Turkey, with Central Bank setting a rate of close to 18%.
Original purpose of creating central banks was to provide a backstop, nothing else
Central banks were formed to prevent massive crises in the banking system. Note that the US Federal Reserve Act is of 1913, and even after that, there was the massive collapse of stocks and the so called Great Depression in 1929. Obviously they couldn't prevent that. More recently, the 2008 crash was not preventable by all the jargon of price stability, interest rate stability and increasing unemployment which the central bank is supposed to provide. What they do provide, is the security when the panic is on and full blowing. They are like firefighters-they do nothing most of the time, but when there is a fire, they will help society. That's how central banks were formed (previously, there were only private banks, who would all go bankrupt together, and the savers would lose their deposit). The FDIC guarantee is an extension of that-to reduce the probability of bank runs and savers losing deposits.
Let's not credit the firefighters for creating the world's tallest buildings and the subway lines. They are there when things go bad; but in reality are an expense when things are going good (They are the put seller on the financial system and savers deposits in the banks).
Everyone likes the guarantee of a central bank (actuallly the FDIC in the US) that their deposits are insured at least upto $200K or $250K. But beyond that, they can't do much. I know personally someone who still can't get $ 5 million they had with Lehman Brothers in 2008. Let's not give too much credit to the central banks in normal times-they really do nothing in those times. Once again, they are very useful in bad times, providing the market support which is necessary; but beyond that, having monthly meetings to set interest rates, looking at all kinds of noisy data like inflation, GDP, employments numbers etc. is a lot of hogwash. They pretend that they can do something about all these numbers; they can't.
For people who believe that a central bank can create money out of thin air, why doesn't the central bank or FDIC guarantee deposits more than $250K per bank? The reason is that they can't take guarantees which will sink themselves. In the 2008 crisis, who bailed out Merrill Lynch, AIG, GE and gave loans to GM etc? It was not the central bank/ Federal Reserve. It was the US Government, with the bill eventually falling on the US taxpayer, the general public. When shit really hits the fan the US Fed goes running to the US Treasury, not the other way around. Because in the end it is the US Government which guarantees the US dollar bills, the circulation of currency, and in reality, all property rights. Federal reserve and the other US banks can do only so much in a financial crisis of the type we saw in 2008, and eventually it is the US Government which bailed the players out. Some like Lehman, Bear Sterns, Fannie Mae and Freddie Mac were left to perish. The baloney about central banks as independent of a government is only hailed by the financial types; in reality, the independence is just to insure that the bank does not give unlimited quantity of money loans to a Government. Beyond that, they really are a part of the US Government (US Treasury), who has the final say in times of real crises, which are the times when you find out who runs the show. The US Fed was an emperor without clothes, and amazingly, even after the crisis, they are given credit for saving the financial system in 2008, not the US Treasury, who was where the buck ultimately stopped. The problem is that a central bank can't take an infinite number of bad loans without sinking itself, and then it has to be bailed out itself by the US taxpayer. Even with the best intentions, there isn't money for everyone, which is why Lehman and Bear Sterns failed, and Merrill Lynch pretty much was force-merged with Bank of America.
When the US Treasury or the US Government rescues a financial institution with the consultation of the Fed, in reality it is the US taxpayer, the real saver in the US, who pays for the bailout. Therefore, once again, one can see that the banking system channels the savers' money into the borrowers hands, very indirectly sometimes as in this case, and it is the savers who run the show of capitalism. Some loan it to banks directly via deposits, some buy Government bonds, other buy stocks; but they all as a group save by these activities, and postpone their immediate consumption to hopefully enjoy bigger fruits later (the whole idea of saving is this; enjoy one cake today or two cakes tomorrow).
Provide price stability is also in the original Fed Reserve Act of 1913. They readily discard the volatile food and energy prices to come up with a smooth inflation number-they promote price stability by discarding volatile data! Poor people spend a lot of money on food; and discarding food and energy costs is clearly not right. Note also that despite all intentions of price stability, prices of commodities, stock market values and people's savings and investments, real estate etc. crash all the time. Clearly they are not able to do much. You can always argue that it would be even worse if there was no central bank-and that's a completely valid argument-but in my opinion, you are giving too much weight to what a central bank can do. The central bank is a bank of banks, and all banks can do is transfer money from real savers to real borrowers-they cannot generate loans out of thin air, otherwise their balance sheets reflect it, and they go belly up. This happened in 2008 to many banks. And it has happened to the central bank as a whole in Venezuela-which is clearly bankrupt. Note that cash held in deposits is a liability for the bank, and the assets and interest payments on them must match these deposits-otherwise a bank, including a central bank like of Venezuela right now, is bankrupt (Assets less than liabilities, and not able to pay interest payments). This is the cause of devaluation of their currencies. The shenanigans of a bankrupt central bank don't last very long, just as the shenanigans of a bankrupt company or individual-soon people get a whiff of it and stop doing business with it. Most products in Venezuela are quoted in USD for this reason. Same with Argentina until recently, when Macri got elected and things seem to have stabilized a bit.
Bank of Japan is buying stocks in the Nikkei to "stimulate the economy and get growth back". See article here. Their interest rate policy didnt get them anywhere for the part 20 years, so now they created another model-let's see if buying stocks creates growth and creates jobs. Banks can't do squat! Economic growth is decided by the hard working Japanese, the real capital owners of Japan, not a bank which is just in the business of transferring funds from lenders to borrowers. They will come up with newer and newer theories of tackling inflation, job growth, unemployment, etc...but will not accept that they have no effect over any of these things.
Here's what Smith said about operations of banking, and how they help us:
"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country. "
See also: What is money and what are its uses