Posted by: Dirk | June 12, 2017

Why I am a horizontalist

Once upon a time, there was a discussion about interest rates set by banks. Do banks:

  1. increase interest rates when they face a specially large demand or
  2. set interest rates and then ignore the demand for loans

The first position is called the verticalist position, the second the horizontalist. The following graph shows the Fed Funds rate, which is heavily influenced by the Fed (up to 100% if it wanted to!), and the bank prime loan rate. FRED explains that it is the “Rate posted by a majority of top 25 (by assets in domestic offices) insured U.S.-chartered commercial banks. Prime is one of several base rates used by banks to price short-term business loans”. The picture is only compatible with the horizontalist position:

 The idea then that when demand for loans is relatively high interest rates are hiked up seems empirically implausible. A more interesting story seems to be that almost every time interest rates are increased by the central bank a recession follows, as shown by the gray bars. While strong loan demand does not lead to increases in the interest rates of banks, at some point the central bank will intervene, very likely to stop inflation running away. If we add change in total credit to private non-financial sector we should have a more complete picture:

Interesting.

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