Interest Rates

Bank operations set real interest rates.

Interest Rates

At their foundation, interest rates are just the cost of bank operations.

If you need to borrow money, you have to go to a private bank. There is no alternative to this in Canada unless you are in Alberta, where you can go to the state-owned bank ATB Financial, but even this publicly owned bank (and credit unions) operate within a logic that is not dissimilar from private banks. Though, it could do with the correct government policy driving it.

If you are a major agro business and you can borrow from Farm Credit Canada. And, if you are looking for very specific financing, you can borrow from the Business Development Bank of Canada. Both of these are Crown companies and meddle with interest rates offered to borrowers, which is fun to keep in mind for a left-wing federal government.

But, the reality is that the vast majority of loans offered are from private, for-profit banks.

Banking is also internationally competitive, like most Capital.

The interest rate is competitive because it is the rate at which a loan can be offered in competition with other banks. If your interest rate is too high, then borrowers will go somewhere else.

If the interest rate is too low, then the bank will not make money and will have to increase interest rates, gain money from other activities, or go out of business.

Of course it more complex than this in real life. Banks are very complex entities and make money from more than just lending money. However, the logic is as sound for lending as it is for any non-bank service that sells thing for less than the price of production.

The impact of these non-lending bank services is important. If the revenue from investing and service fees declines, then the bank cannot subsidize its lending interest rate and must increase it.

Why does this understanding of interest rates matter?

Because the debate right now is about increasing central bank rates. This is the rate that the central bank lends to private banks.

The profit rate of private banks is the difference between the real interest rate (the rate of operations of the bank) and the rate that it offers its clients.

But, this rate is also dependent on the rate that it borrows money from the central bank. If the interest rate that the central bank offers private banks is lower than the actual interest rate, then banks profit from borrowing. This is partly how the central bank creates an incentives to "print" money.

At a certain level of difference between the central bank interest rate and private bank real rates, the artificially low interest rate of the central bank becomes a direct profit subsidy to banks.

The current central bank response to high inflation is to take away this profit subsidy to banks, forcing them to increase the price of loans to business (regular people are caught-up in this, of course). Increased costs of debt increases costs to firms that make stuff and provide services.

If these firms are in a competitive environment, then their ability to increase prices is limited by that competition. The "macro" effect is that some businesses will go out of business faster/earlier than they would with subsidized interest rates.

When we say that central banks are trying to drive us into a recession, we just mean they are trying to put unprofitable businesses out of business. But, central banks are very bad at doing this with any precision, because the economy is way more complex than this. And, they usually end-up putting marginally profitable firms out of business.

Why do we care about this? Because, firms that go out of business employ people and might be providing a needed service or production process for people.