Compound Interest Is Exponentially More Powerful Than the Federal Reserve’s Attempts at Price Controls

As readers are already aware, there’s always lots of speculation and panting by the deep-in-thought ahead of interest rate decisions by the Federal Reserve. But rather than fill many books with just how absurd the notion of central credit planning is, how about we just reduce it to the absurd: what if the Fed had raised the funds rate to 36% last week? Would it mean anything? No, not really. Think about it.

Does anyone seriously think Jeff Bezos would have to pay 36% in order to borrow at the Fed’s artificially arrived at rate of interest? Hopefully the question answers itself, but if not the obvious reality is that Bezos wouldn’t even pay anywhere close to the present 5% rate that the Fed arrived at last Wednesday. Billionaires borrow much more cheaply than you and I do.

Considering the above once again through the absurdist prism of 36%, the vast majority of Americans wouldn’t pay anywhere close to 36% to borrow. That’s true firstly because banks by virtue of being banks can’t take risks remotely resembling a loan that would rate a 36% rate of interest. That’s is so because loans made by banks must perform, and a 36% rate of interest is a market signal suggesting high odds that the loan won’t be repaid. A high rate of interest is what a lender demands in “rent” in return for the possibility that the borrower will be delinquent on the rent. Banks yet again don’t take such risks.

Just as banks won’t lend at nosebleed levels if the Fed decrees such, neither will lenders in general. An artificially high price control is merely a sign that markets would and will speak, only for voluminous lending from those with title to money at rates well below the artificially high one.

At the same time, 36% is a rate of interest that is plainly too low for borrowers with limited means. Let’s call them “subprime borrowers.” Economists J. Brandon Bolen, Gregory Elliehausen, and Thomas Miller conducted a detailed study of artificial rates of interest in the aftermath of the 2021 passage of the Predatory Loan Prevention Act in Illinois. The latter put a 36% ceiling on what non-bank financial institutions could charge subprime borrowers.

What Bolen et al discovered was what economic theory has long supported: the imposition of an artificially low rate of interest would result in reduced lending. That’s certainly what happened to subprime borrowers in Illinois. Some were even too risky at 36%. Markets always have their say, and they do without regard to what central bankers might decree.

It’s all a reminder that the Federal Reserve engages in price controls without prices actually being controlled. When the central bank is at zero, there’s no lending at zero simply because credit is never costless. And it’s not costless because the most powerful investment force in the world is compound interest. The power of the previous truth tells us that while the Fed can operate in a parallel universe, there will always be a very real (and sometimes substantial) cost to accessing the goods, services and human capital that money can be exchanged for.

Just the same, artificially high rates of interest will similarly give off unreal connotations. Compound interest’s genius yet again requires that wealth be put to work, which means a Fed at 36% would reside in a parallel universe rather resemblant of central banks at zero.