WEBVTT 00:00:00.000 --> 00:00:01.679 Okay, let's unpack this. We're going to talk 00:00:01.679 --> 00:00:05.179 about the single most influential number in all 00:00:05.179 --> 00:00:07.759 of global finance. It's a number that determines 00:00:07.759 --> 00:00:10.119 if your savings actually grow or if they shrink, 00:00:10.220 --> 00:00:13.800 if a business can expand, and if that house you 00:00:13.800 --> 00:00:15.660 want is even affordable. We're talking about 00:00:15.660 --> 00:00:17.820 the interest rate. Yeah, and it's so often just 00:00:17.820 --> 00:00:21.309 boiled down to the cost of money. But that definition, 00:00:21.469 --> 00:00:23.750 I mean, it's deceptively simple, isn't it? It 00:00:23.750 --> 00:00:25.809 really is. We're actually talking about the fundamental 00:00:25.809 --> 00:00:28.469 mechanism that central banks use to steer entire 00:00:28.469 --> 00:00:31.329 economies. It's a concept that has seen some 00:00:31.329 --> 00:00:33.210 incredible extremes. You mean swinging from, 00:00:33.310 --> 00:00:35.570 what was it, 800 % annual rates in some places? 00:00:35.850 --> 00:00:40.630 800 % in moments of desperate economic crisis 00:00:40.630 --> 00:00:43.109 all the way down to, and this is the really surprising 00:00:43.109 --> 00:00:45.990 part, tipping below zero in the last decade or 00:00:45.990 --> 00:00:50.119 so. That volatility, that sheer drama is exactly 00:00:50.119 --> 00:00:52.619 why we're doing this deep dive. We've gone through 00:00:52.619 --> 00:00:55.140 a comprehensive stack of source material, all 00:00:55.140 --> 00:00:57.859 focused on this one concept. And our mission 00:00:57.859 --> 00:01:00.340 for you, the learner, is to give you a complete 00:01:00.340 --> 00:01:02.979 foundational understanding. We're going to start 00:01:02.979 --> 00:01:05.310 with the absolute basics. Right. We'll hit the 00:01:05.310 --> 00:01:07.450 crucial difference between nominal and real value 00:01:07.450 --> 00:01:09.930 first. Then we'll move through the mechanics 00:01:09.930 --> 00:01:12.269 of how central banks try to control it, including 00:01:12.269 --> 00:01:14.189 some of those extreme policies we just mentioned. 00:01:14.390 --> 00:01:16.549 And then finally, we'll dissect all the little 00:01:16.549 --> 00:01:19.290 pieces, the granular components that determine 00:01:19.290 --> 00:01:22.109 the specific rate you get from, say, your local 00:01:22.109 --> 00:01:24.709 bank. Exactly. The goal here is to leave you 00:01:24.709 --> 00:01:28.150 not just informed, but genuinely fluent in the 00:01:28.150 --> 00:01:30.730 language of interest rates. We want to clarify 00:01:30.730 --> 00:01:33.250 all those essential distinctions and show you 00:01:33.250 --> 00:01:36.340 exactly how this one number impacts everything. 00:01:36.680 --> 00:01:39.840 The big macroeconomic outcomes output, employment. 00:01:40.159 --> 00:01:42.760 And critically, the long -term stability of your 00:01:42.760 --> 00:01:45.640 own savings and your pension fund. Okay, so let's 00:01:45.640 --> 00:01:47.760 establish that foundation. What is the core definition 00:01:47.760 --> 00:01:50.319 we're working with here? At its most basic level, 00:01:50.459 --> 00:01:53.239 the interest rate is the amount of interest due 00:01:53.239 --> 00:01:56.939 per period. And it's expressed as a percentage 00:01:56.939 --> 00:01:59.840 of the amount that was lent or deposited or borrowed. 00:02:00.000 --> 00:02:01.840 So it's the price of capital, but it's also... 00:02:02.079 --> 00:02:04.079 In a way, the price of time. That's a perfect 00:02:04.079 --> 00:02:06.900 way to put it. It reflects a borrower's willingness 00:02:06.900 --> 00:02:10.259 to pay a premium to have money now instead of 00:02:10.259 --> 00:02:11.900 having that same amount of money in the future. 00:02:12.520 --> 00:02:15.099 The lender, on the other hand, gets compensated 00:02:15.099 --> 00:02:17.479 for delaying their own spending. Right. So think 00:02:17.479 --> 00:02:19.979 about a big company. When it decides to take 00:02:19.979 --> 00:02:22.379 on debt, maybe issue some bonds or get a loan, 00:02:22.539 --> 00:02:26.020 they're making a very specific calculated bet. 00:02:26.219 --> 00:02:29.259 A gamble, really. Yeah, a gamble. They're betting 00:02:29.259 --> 00:02:31.949 that the money they borrow. will generate a return 00:02:31.949 --> 00:02:34.689 on their investment that's significantly greater 00:02:34.689 --> 00:02:36.250 than the interest rate they have to pay back. 00:02:36.469 --> 00:02:39.129 And that gap, that space between the cost of 00:02:39.129 --> 00:02:41.310 borrowing and the return they generate, that 00:02:41.310 --> 00:02:43.889 is the engine that drives economic growth. If 00:02:43.889 --> 00:02:45.990 they can't make those interest payments, that 00:02:45.990 --> 00:02:48.750 gap shrinks or just disappears entirely. Which 00:02:48.750 --> 00:02:51.729 leads directly to financial distress, default, 00:02:52.069 --> 00:02:54.960 and maybe even bankruptcy. Which is why the interest 00:02:54.960 --> 00:02:57.000 rate is basically the gatekeeper for investment 00:02:57.000 --> 00:02:59.939 decisions across the entire globe. Now, we have 00:02:59.939 --> 00:03:02.360 to remember that the rate itself, that percentage, 00:03:02.599 --> 00:03:05.620 is only one piece of the puzzle. The sources 00:03:05.620 --> 00:03:08.659 remind us there are three other variables that 00:03:08.659 --> 00:03:10.840 work with the rate to determine the total interest 00:03:10.840 --> 00:03:13.030 you end up paying or receiving. And these are 00:03:13.030 --> 00:03:15.229 crucial for anyone taking out a loan. First, 00:03:15.409 --> 00:03:17.129 you've got the principal sum. That's the actual 00:03:17.129 --> 00:03:18.710 amount you borrowed in the first place. Okay, 00:03:18.750 --> 00:03:22.110 so the lump sum. Exactly. Second is the compounding 00:03:22.110 --> 00:03:25.370 frequency. This one is huge. It's how often the 00:03:25.370 --> 00:03:27.349 interest calculation is applied to your balance. 00:03:28.250 --> 00:03:30.990 Interest that's compounded daily is way more 00:03:30.990 --> 00:03:33.050 expensive than interest compounded annually, 00:03:33.210 --> 00:03:35.830 even if the stated rate is identical. And the 00:03:35.830 --> 00:03:38.409 third one is just the length of time, the total 00:03:38.409 --> 00:03:40.750 duration of the loan or the deposit. Yeah, a 00:03:40.750 --> 00:03:43.069 30 -year mortgage. even at what seems like a 00:03:43.069 --> 00:03:45.990 low rate, racks up a staggering amount of total 00:03:45.990 --> 00:03:49.250 interest compared to, say, a five -year car loan, 00:03:49.530 --> 00:03:51.889 the time horizon makes all the difference. So 00:03:51.889 --> 00:03:54.569 all four principle, rate, frequency, and time, 00:03:54.629 --> 00:03:57.009 they all work together. They create the final 00:03:57.009 --> 00:03:59.669 cost of capital. Now, going back to this idea 00:03:59.669 --> 00:04:02.590 of it being the most influential number, it's 00:04:02.590 --> 00:04:04.210 really important for you to know that when you 00:04:04.210 --> 00:04:07.020 hear... financial news anchors or economists 00:04:07.020 --> 00:04:10.199 say the interest rate, they're usually using 00:04:10.199 --> 00:04:12.659 it as shorthand. Shorthand for a very specific 00:04:12.659 --> 00:04:15.159 rate. Right. They mean the central bank's policy 00:04:15.159 --> 00:04:17.959 rate. So in the US, that's the Federal Reserve's 00:04:17.959 --> 00:04:20.680 federal funds rate, the FFR. Yeah. In the UK, 00:04:20.879 --> 00:04:23.160 it would be the official bank rate from the Bank 00:04:23.160 --> 00:04:26.279 of England. Precisely. And because those rates 00:04:26.279 --> 00:04:29.240 dictate what it costs commercial banks to lend 00:04:29.240 --> 00:04:31.920 to each other overnight, they just cascade through 00:04:31.920 --> 00:04:34.259 the entire financial system. They become the 00:04:34.259 --> 00:04:36.500 foundation, the base rate that everything else 00:04:36.500 --> 00:04:38.459 is built on. And you hear a bunch of other terms 00:04:38.459 --> 00:04:40.699 that are all related to this, like the repo rate, 00:04:40.800 --> 00:04:43.509 the prime rate, the discount rate. And they all 00:04:43.509 --> 00:04:46.170 describe slightly different mechanisms. The rate 00:04:46.170 --> 00:04:48.470 banks lend to each other versus the rate they 00:04:48.470 --> 00:04:50.949 offer their best corporate customers. But they 00:04:50.949 --> 00:04:53.589 all fundamentally link back to that one central 00:04:53.589 --> 00:04:56.709 cost of borrowing. OK, that sets our foundational 00:04:56.709 --> 00:05:00.069 language. Now we can move into what is arguably 00:05:00.069 --> 00:05:02.529 the most critical distinction for anyone who 00:05:02.529 --> 00:05:04.689 wants to really understand the headlines. This 00:05:04.689 --> 00:05:06.610 is where we get into the difference between nominal 00:05:06.610 --> 00:05:09.759 and real rates. And this is the moment you realize 00:05:09.759 --> 00:05:12.180 that the rate you see posted on your savings 00:05:12.180 --> 00:05:16.579 account can often be, well, an illusion, especially 00:05:16.579 --> 00:05:19.540 when you factor in inflation. It's paramount, 00:05:19.540 --> 00:05:21.420 this distinction, because the buying power of 00:05:21.420 --> 00:05:23.920 our money is constantly shifting. The nominal 00:05:23.920 --> 00:05:26.240 interest rate is the easy one. It's just the 00:05:26.240 --> 00:05:28.160 stated percentage you see on the loan agreement. 00:05:28.360 --> 00:05:30.939 It's the number, no adjustments. But the real 00:05:30.939 --> 00:05:33.000 interest rate is the one that actually matters 00:05:33.000 --> 00:05:35.660 for your wealth. Yes, because it accounts for 00:05:35.660 --> 00:05:38.480 inflation. The real rate measures your interest 00:05:38.480 --> 00:05:41.060 by comparing the final sum against the buying 00:05:41.060 --> 00:05:43.740 power of that money when the deal started. It's 00:05:43.740 --> 00:05:45.620 about what you can buy with it, not just the 00:05:45.620 --> 00:05:47.540 number of dollars. So here's the aha moment, 00:05:47.740 --> 00:05:50.480 right? If you're earning 5 % nominal interest 00:05:50.480 --> 00:05:54.139 on your savings, but inflation is also 5%, then 00:05:54.139 --> 00:05:56.779 your real interest rate is zero. You've gained 00:05:56.779 --> 00:05:59.100 absolutely no buying power. You're just treading 00:05:59.100 --> 00:06:01.879 water against the current of rising prices. And 00:06:01.879 --> 00:06:04.639 worse, if inflation is higher than your nominal 00:06:04.639 --> 00:06:07.819 rate, say inflation is 8 % and your account pays 00:06:07.819 --> 00:06:10.600 5%, then you actually have a negative real interest 00:06:10.600 --> 00:06:12.819 rate. Your wealth is actively shrinking in real 00:06:12.819 --> 00:06:15.139 terms. Even though the dollar amount in your 00:06:15.139 --> 00:06:17.779 bank account is technically going up, it buys 00:06:17.779 --> 00:06:20.759 you less and less each year. So we formalize 00:06:20.759 --> 00:06:22.259 this with something called the Fisher equation. 00:06:22.620 --> 00:06:25.740 Our sources give us the precise mathematical 00:06:25.740 --> 00:06:29.319 formula for it. Right, which is 1 plus i, 1 plus 00:06:29.319 --> 00:06:32.319 p, 1, 1. And that's the academically correct 00:06:32.319 --> 00:06:35.019 multiplicative way to do it, where r is the real 00:06:35.019 --> 00:06:38.519 rate, i is nominal, and p is inflation. But thankfully, 00:06:38.660 --> 00:06:40.860 for most everyday situations where rates are 00:06:40.860 --> 00:06:43.180 low, there's a much simpler way to think about 00:06:43.180 --> 00:06:45.199 it, an approximation that gets the logic across 00:06:45.199 --> 00:06:47.660 perfectly. That's right. And that core logic 00:06:47.660 --> 00:06:49.959 is just simple subtraction. The real rate is 00:06:49.959 --> 00:06:52.139 approximately the nominal rate minus the inflation 00:06:52.139 --> 00:06:54.540 rate. So three at a rocks, IPU. That's so much 00:06:54.540 --> 00:06:56.199 more intuitive. It lets you just instantly gauge 00:06:56.199 --> 00:06:58.379 the real return on your money. But there's an 00:06:58.379 --> 00:07:00.600 important detail here about when we apply this 00:07:00.600 --> 00:07:03.639 equation. It's used both ex ante and ex post. 00:07:04.170 --> 00:07:06.709 Which means before the event and after the event. 00:07:06.850 --> 00:07:09.350 Exactly. Ex -ante is when you're projecting. 00:07:09.629 --> 00:07:11.470 If you're the Federal Reserve setting policy 00:07:11.470 --> 00:07:13.649 today, you have to use an expected inflation 00:07:13.649 --> 00:07:15.870 rate for the next year or two. You're forecasting. 00:07:16.149 --> 00:07:19.149 And ex -post is when you look back. A year later, 00:07:19.189 --> 00:07:21.670 you plug in the actual inflation that happened 00:07:21.670 --> 00:07:23.810 to see what the real interest rate truly was. 00:07:24.009 --> 00:07:26.470 And the gap between that forecast and the reality 00:07:26.470 --> 00:07:29.350 is huge. If a central bank gets its inflation 00:07:29.350 --> 00:07:31.970 projection wrong, the real interest rate ends 00:07:31.970 --> 00:07:34.170 up being different than they intended, which 00:07:34.170 --> 00:07:36.990 can either overstimulate or overtighten the economy. 00:07:37.370 --> 00:07:39.889 It's often the key to whether monetary policy 00:07:39.889 --> 00:07:43.170 succeeds or fails. OK, moving on from that core 00:07:43.170 --> 00:07:45.829 concept, let's quickly clarify a few other terms 00:07:45.829 --> 00:07:48.129 you might run into, like in consumer. finance. 00:07:48.189 --> 00:07:51.370 Things like APR and AER. Right. The annual percentage 00:07:51.370 --> 00:07:53.930 rate or APR you see on credit cards and car loans. 00:07:54.149 --> 00:07:56.009 But it's vital to know the difference between 00:07:56.009 --> 00:07:59.769 the nominal APR and the effective APR or EAPR. 00:07:59.970 --> 00:08:02.889 The EAPR is the real cost because it includes 00:08:02.889 --> 00:08:05.550 all the compounding and any mandatory fees like 00:08:05.550 --> 00:08:08.050 an origination fee on a loan. Yeah, the nominal 00:08:08.050 --> 00:08:10.790 APR often leaves those fees out, which can make 00:08:10.790 --> 00:08:12.470 the loan look a lot cheaper than it actually 00:08:12.470 --> 00:08:14.910 is. And then there's AER, the annual equivalent 00:08:14.910 --> 00:08:17.410 rate, which you see on savings accounts. AER 00:08:17.410 --> 00:08:20.069 is similar in that it factors in the compounding 00:08:20.069 --> 00:08:23.430 frequency. But unlike EAPR, it typically does 00:08:23.430 --> 00:08:26.009 not account for any fees for holding the account. 00:08:26.250 --> 00:08:29.089 And finally, in the investment world, you have 00:08:29.089 --> 00:08:32.850 yield to maturity, or YTM. That's a bond -specific 00:08:32.850 --> 00:08:36.070 term. It's essentially the total annualized rate 00:08:36.070 --> 00:08:38.350 of return you'd get if you bought a bond today 00:08:38.350 --> 00:08:40.730 and held it until the very end, until it matures 00:08:40.730 --> 00:08:42.769 and pays you back the principal. It accounts 00:08:42.769 --> 00:08:44.750 for all the coupon payments and the price you 00:08:44.750 --> 00:08:47.190 paid for it. Okay. So we've defined the price 00:08:47.190 --> 00:08:49.450 of money. We've clarified the crucial difference 00:08:49.450 --> 00:08:51.929 between the stated rate and the real rate. Now 00:08:51.929 --> 00:08:53.629 we dive into the machine that actually controls 00:08:53.629 --> 00:08:57.279 this number, Section 3, monetary policy. Interest 00:08:57.279 --> 00:08:59.539 rate targets are, without a doubt, the most powerful 00:08:59.539 --> 00:09:01.580 tool central banks have. They use them to try 00:09:01.580 --> 00:09:05.879 and manage that macroeconomic holy trinity, investment 00:09:05.879 --> 00:09:09.059 levels, inflation and unemployment. And the basic 00:09:09.059 --> 00:09:10.840 strategy is pretty straightforward, right? You 00:09:10.840 --> 00:09:13.120 cut rates to stimulate the economy. Exactly. 00:09:13.139 --> 00:09:15.539 You lower rates, borrowing becomes cheaper, and 00:09:15.539 --> 00:09:18.279 that encourages firms to expand and consumers 00:09:18.279 --> 00:09:21.679 to like, you know. buy a house or a car. And 00:09:21.679 --> 00:09:23.720 conversely, you raise rates when the economy 00:09:23.720 --> 00:09:25.840 is overheating and inflation is getting out of 00:09:25.840 --> 00:09:28.600 control. You pump the brakes. Higher rates make 00:09:28.600 --> 00:09:31.080 borrowing more expensive, which slows down spending 00:09:31.080 --> 00:09:33.299 and investment and hopefully brings inflation 00:09:33.299 --> 00:09:35.659 back into line. But the sources are clear that 00:09:35.659 --> 00:09:38.340 this is a delicate balancing act, keeping rates 00:09:38.340 --> 00:09:41.159 low for too long while it feels good. can be 00:09:41.159 --> 00:09:43.899 really risky. It can lead to economic bubbles. 00:09:44.139 --> 00:09:47.179 If capital is too cheap for too long, you can 00:09:47.179 --> 00:09:50.159 see a flood of investment into specific sectors 00:09:50.159 --> 00:09:53.159 like real estate or the stock market, pushing 00:09:53.159 --> 00:09:55.759 prices way beyond their fundamental value. We 00:09:55.759 --> 00:09:57.720 all know how that ends. To really appreciate 00:09:57.720 --> 00:10:01.179 the power of this policy lever, you have to look 00:10:01.179 --> 00:10:03.340 at the historical volatility. The numbers are, 00:10:03.460 --> 00:10:07.000 frankly, wild. They are extreme and they show 00:10:07.000 --> 00:10:09.460 just how fragile the value of money can be under 00:10:09.460 --> 00:10:11.419 pressure. Our sources give us some incredible 00:10:11.419 --> 00:10:14.220 examples. The U .S. federal funds rate, for instance, 00:10:14.399 --> 00:10:17.919 it's been as low as 0 .25 percent, but it also 00:10:17.919 --> 00:10:22.500 hit a peak of nearly 19 percent in 1981. 19%. 00:10:22.500 --> 00:10:25.320 That was Fed Chair Paul Volcker's shock therapy 00:10:25.320 --> 00:10:28.620 to kill the runaway inflation of the 1970s. Can 00:10:28.620 --> 00:10:30.419 you imagine trying to get a mortgage at that 00:10:30.419 --> 00:10:33.539 rate? Unthinkable today. And the U .K. saw similar 00:10:33.539 --> 00:10:37.179 swings between 0 .5 % and 15%. But those are 00:10:37.179 --> 00:10:39.559 in relatively stable economies. The real shock 00:10:39.559 --> 00:10:42.039 comes when you look at places dealing with hyperinflation. 00:10:42.179 --> 00:10:45.360 Take Germany in the 1920s. After the Weimar Republic's 00:10:45.360 --> 00:10:47.480 hyperinflation completely destroyed their currency, 00:10:47.799 --> 00:10:50.620 they had to push rates up to almost 90 % just 00:10:50.620 --> 00:10:53.470 to try and stabilize things. 90%. I mean, how 00:10:53.470 --> 00:10:55.909 does an economy even function? It barely does, 00:10:56.070 --> 00:10:58.909 but that's nothing compared to Zimbabwe. In 2007, 00:10:59.049 --> 00:11:01.409 as their currency was becoming worthless, their 00:11:01.409 --> 00:11:04.049 central bank raised borrowing rates to 800%. 00:11:04.049 --> 00:11:07.009 800. That's not even an economic policy at that 00:11:07.009 --> 00:11:09.029 point, is it? It's just a sign of complete collapse. 00:11:09.610 --> 00:11:12.009 It's a desperate emergency measure. It's basically 00:11:12.009 --> 00:11:14.029 the central bank throwing its hands up and saying 00:11:14.029 --> 00:11:17.110 the formal monetary system has failed. Very little 00:11:17.110 --> 00:11:19.210 legitimate borrowing happens at that rate because 00:11:19.210 --> 00:11:21.909 inflation is probably running even higher. The 00:11:21.909 --> 00:11:24.850 economy just reverts to cash or barter. Which 00:11:24.850 --> 00:11:26.909 puts another detail from the sources into context. 00:11:27.110 --> 00:11:30.309 It says that during the 1970s and 80s, interest 00:11:30.309 --> 00:11:32.789 rates on prime credit were higher than any previous 00:11:32.789 --> 00:11:36.350 peaks recorded since, like, the 1600s. Yes, the 00:11:36.350 --> 00:11:38.809 source is emphatic about that. It says, since 00:11:38.809 --> 00:11:40.909 modern capital markets came into existence, there 00:11:40.909 --> 00:11:44.190 have never been such high long -term rates. That 00:11:44.190 --> 00:11:46.289 inflation fight in the late 20th century was 00:11:46.289 --> 00:11:48.490 an absolutely unprecedented global financial 00:11:48.490 --> 00:11:50.970 event. So that shows the high end of the range. 00:11:51.350 --> 00:11:54.090 But the last 15 years have all been about exploring 00:11:54.090 --> 00:11:56.990 the other boundary, pushing toward the floor. 00:11:57.450 --> 00:11:59.789 Which brings us to the zero interest rate policy, 00:11:59.990 --> 00:12:04.519 or ZRP. ZRP is when a central bank sets its target 00:12:04.519 --> 00:12:07.679 rate extremely low, near zero. And the main challenge 00:12:07.679 --> 00:12:09.220 it tries to deal with is something called the 00:12:09.220 --> 00:12:11.580 zero lower bound. The ZLB. This is the traditional 00:12:11.580 --> 00:12:14.220 idea that you can't really push rates below zero, 00:12:14.259 --> 00:12:17.720 right? Historically, yes. The thinking was if 00:12:17.720 --> 00:12:19.960 a bank tried to charge you a negative rate, say 00:12:19.960 --> 00:12:23.559 they take 0 .5 % of your deposit each year, you 00:12:23.559 --> 00:12:25.279 would just pull your money out. And stuff it 00:12:25.279 --> 00:12:28.039 under the mattress. Exactly. Because cash has 00:12:28.039 --> 00:12:31.340 a guaranteed return of exactly 0%. So hoarding 00:12:31.340 --> 00:12:33.580 cash becomes more attractive than accepting a 00:12:33.580 --> 00:12:35.700 guaranteed loss at the bank, which makes the 00:12:35.700 --> 00:12:38.159 central bank's policy ineffective. And the U 00:12:38.159 --> 00:12:41.440 .S. used ZRP aggressively after the 2008 crisis, 00:12:41.639 --> 00:12:44.899 from 2008 to 2015, and then again during the 00:12:44.899 --> 00:12:47.480 COVID pandemic. It's a signal that the economy 00:12:47.480 --> 00:12:50.690 is so weak. or the risk of deflation is so high 00:12:50.690 --> 00:12:52.929 that the central bank has basically run out of 00:12:52.929 --> 00:12:54.970 its normal ammunition. Which brings us to where 00:12:54.970 --> 00:12:58.210 things got really weird in the 2010s. Yeah. Actually 00:12:58.210 --> 00:13:00.710 trying to break through that zero lower bound. 00:13:00.929 --> 00:13:03.149 And here we have to distinguish between two kinds 00:13:03.149 --> 00:13:05.889 of negative rates, negative real rates and negative 00:13:05.889 --> 00:13:07.970 nominal rates. A negative real rate, as we said, 00:13:08.029 --> 00:13:10.429 is actually pretty common. It's just when inflation 00:13:10.429 --> 00:13:13.210 is higher than your nominal interest rate. Your 00:13:13.210 --> 00:13:15.850 purchasing power is shrinking. And when this 00:13:15.850 --> 00:13:18.500 is done as a deliberate government policy. It's 00:13:18.500 --> 00:13:21.340 called financial repression. This was a key policy 00:13:21.340 --> 00:13:24.480 in the US and the UK after World War II, wasn't 00:13:24.480 --> 00:13:27.840 it? It was. Through the late 1970s, it was essential 00:13:27.840 --> 00:13:30.080 for managing the massive debts they'd accumulated 00:13:30.080 --> 00:13:33.399 during the war. It's a way for governments to 00:13:33.399 --> 00:13:35.980 inflate away the real value of their debt. So 00:13:35.980 --> 00:13:37.779 it's basically a stealth tax on anyone who saves 00:13:37.779 --> 00:13:40.299 money. That's precisely what it is. You keep 00:13:40.299 --> 00:13:42.860 nominal rates low, but you let inflation run 00:13:42.860 --> 00:13:46.309 hot. This guarantees a negative real return for 00:13:46.309 --> 00:13:49.389 bondholders and savers, which reduces the government's 00:13:49.389 --> 00:13:51.830 real debt burden over time without having to 00:13:51.830 --> 00:13:55.409 explicitly default or raise taxes in a way that's 00:13:55.409 --> 00:13:57.809 politically unpopular. It's not an obvious tax. 00:13:58.169 --> 00:14:01.500 It's a slow, confusing erosion of wealth. that 00:14:01.500 --> 00:14:03.500 most people don't immediately trace back to a 00:14:03.500 --> 00:14:05.940 specific policy. And the historical record shows 00:14:05.940 --> 00:14:08.500 how savers felt about it. The source notes that 00:14:08.500 --> 00:14:11.220 by the late 1970s, U .S. Treasury bonds were 00:14:11.220 --> 00:14:14.500 being called, pejoratively, certificates of confiscation. 00:14:14.580 --> 00:14:16.320 That tells you everything you need to know. Okay, 00:14:16.379 --> 00:14:19.000 so that's negative real rates. Now for the most 00:14:19.000 --> 00:14:21.980 extreme measure. Negative nominal rate policy, 00:14:22.179 --> 00:14:25.320 or NIRP. This is where the central bank's target 00:14:25.320 --> 00:14:28.159 rate itself is set below zero. Which, according 00:14:28.159 --> 00:14:30.419 to the zero lower bound theory, shouldn't really 00:14:30.419 --> 00:14:33.980 work. So how did this idea even come about? Well, 00:14:34.139 --> 00:14:36.460 we have to go back to the late 19th century to 00:14:36.460 --> 00:14:39.519 a German merchant named Silvio Giselle. Giselle. 00:14:40.000 --> 00:14:42.860 He proposed this as part of a free economy idea, 00:14:43.039 --> 00:14:46.580 right? Freigeld or free money? That's it. He 00:14:46.580 --> 00:14:49.740 saw the negative interest rate as a tax on holding 00:14:49.740 --> 00:14:53.000 money. His big concern was that if people just 00:14:53.000 --> 00:14:55.600 hoarded cash, the economy would stagnate. So 00:14:55.600 --> 00:14:58.019 he designed a system to force money to circulate. 00:14:58.059 --> 00:15:00.620 He suggested issuing currency that literally 00:15:00.620 --> 00:15:03.379 expired. Imagine a banknote with an expiration 00:15:03.379 --> 00:15:06.340 date. To keep it valid, you'd have to pay a small 00:15:06.340 --> 00:15:09.159 fee, maybe by affixing a stamp, to exchange it 00:15:09.159 --> 00:15:11.539 for a new bill. If you tried to hoard it, it 00:15:11.539 --> 00:15:14.120 would just become worthless. That was the original, 00:15:14.240 --> 00:15:16.460 very clever solution to the zero lower bound 00:15:16.460 --> 00:15:18.659 problem. And this idea wasn't just some fringe 00:15:18.659 --> 00:15:21.080 theory. It actually caught the attention of major 00:15:21.080 --> 00:15:24.500 economists. Oh, yeah. John Maynard Keynes gave 00:15:24.500 --> 00:15:27.080 it a serious look in his masterwork, the general 00:15:27.080 --> 00:15:29.899 theory. And he liked the principle, but he dismissed 00:15:29.899 --> 00:15:32.440 it. Why? He saw it as too difficult to administer 00:15:32.440 --> 00:15:35.210 at the time. The logistics of printing new bills, 00:15:35.269 --> 00:15:38.590 stamping them, it seemed too clunky for a national 00:15:38.590 --> 00:15:41.929 economy in the 1930s. Technology has obviously 00:15:41.929 --> 00:15:44.850 changed that calculation. The thought experiments 00:15:44.850 --> 00:15:47.529 kept coming, though. The sources mention ideas 00:15:47.529 --> 00:15:50.409 like magnetic strips on bills to track how long 00:15:50.409 --> 00:15:52.549 they've been out of a bank. And levying a tax 00:15:52.549 --> 00:15:54.889 based on that time. Or my personal favorite. 00:15:55.309 --> 00:15:57.070 The serial number lottery. The one where you 00:15:57.070 --> 00:15:59.049 just announced that all bills ending in a certain 00:15:59.049 --> 00:16:01.330 digit are now worthless. It's a brilliant thought 00:16:01.330 --> 00:16:03.590 experiment. You draw it once a year, and on average, 00:16:03.789 --> 00:16:06.990 cash hoarders lose 10%. It's a functional negative 00:16:06.990 --> 00:16:09.490 interest rate with almost no logistical overhead. 00:16:09.830 --> 00:16:11.990 So these ideas were floating around for decades, 00:16:12.149 --> 00:16:15.370 but NRP actually moved from theory to practice 00:16:15.370 --> 00:16:17.830 in the last decade, mostly in Europe and Japan. 00:16:18.279 --> 00:16:20.860 Starting in 2014, the European Central Bank went 00:16:20.860 --> 00:16:22.940 negative, charging commercial banks to hold their 00:16:22.940 --> 00:16:25.759 excess reserves. The Bank of Japan followed in 00:16:25.759 --> 00:16:29.600 2016, specifically trying to break Japan's entrenched 00:16:29.600 --> 00:16:32.480 deflationary mindset. And it wasn't just them. 00:16:32.919 --> 00:16:35.340 Sweden, Denmark, Switzerland, they all implemented 00:16:35.340 --> 00:16:38.039 an ROP as well. And there's a fascinating technical 00:16:38.039 --> 00:16:41.840 detail from Sweden. Back in 2009, their central 00:16:41.840 --> 00:16:44.759 bank, the Riksbank, set its main policy rate 00:16:44.759 --> 00:16:48.919 at 0 .25%. But at the same time, they set their 00:16:48.919 --> 00:16:52.919 overnight deposit rate at negative 0 .25%. So 00:16:52.919 --> 00:16:55.399 they were actively penalizing banks for parking 00:16:55.399 --> 00:16:57.700 cash with them overnight. It was more of a technical 00:16:57.700 --> 00:17:00.399 consequence at first. The deposit rate was automatically 00:17:00.399 --> 00:17:03.299 set a certain amount below the policy rate. So 00:17:03.299 --> 00:17:06.490 as the policy rate neared zero. The deposit rate 00:17:06.490 --> 00:17:09.210 just slipped into negative territory. But the 00:17:09.210 --> 00:17:11.369 crucial thing is they studied it and found it 00:17:11.369 --> 00:17:13.609 caused almost no disruption, which gave other 00:17:13.609 --> 00:17:15.829 central banks the confidence to try it more deliberately 00:17:15.829 --> 00:17:17.730 later. And it wasn't just central bank rates. 00:17:17.809 --> 00:17:19.789 This bled into government debt markets, too. 00:17:19.930 --> 00:17:22.529 Yes. During the European debt crisis, bonds from 00:17:22.529 --> 00:17:24.609 super safe countries like Germany and Switzerland 00:17:24.609 --> 00:17:27.130 were actually selling at negative yields. Meaning 00:17:27.130 --> 00:17:29.190 investors were paying those governments for the 00:17:29.190 --> 00:17:31.500 privilege of lending them money. Which seems 00:17:31.500 --> 00:17:34.279 completely backwards. It is. But there are powerful 00:17:34.279 --> 00:17:36.740 reasons. First was just an intense desire for 00:17:36.740 --> 00:17:39.799 safety. A small guaranteed loss was seen as a 00:17:39.799 --> 00:17:42.099 better bet than a potentially huge loss elsewhere. 00:17:42.359 --> 00:17:44.859 And the other reason was speculation about the 00:17:44.859 --> 00:17:47.740 Eurozone breaking up. Exactly. Holding a German 00:17:47.740 --> 00:17:51.339 bond was seen as a hedge. If the Eurozone fractured, 00:17:51.420 --> 00:17:53.859 Germany would presumably redenominate its debt 00:17:53.859 --> 00:17:57.529 into a new, stronger currency. So the negative 00:17:57.529 --> 00:17:59.410 yield was basically the price of an insurance 00:17:59.410 --> 00:18:03.109 policy against a total system collapse. So rates 00:18:03.109 --> 00:18:05.230 are volatile. Central banks have immense power. 00:18:05.309 --> 00:18:08.309 They can even go below zero. Let's now look at 00:18:08.309 --> 00:18:10.470 how those changes actually filter down into the 00:18:10.470 --> 00:18:14.539 real economy. Section four. Macroeconomic impact. 00:18:14.759 --> 00:18:16.680 This whole process is called the monetary transmission 00:18:16.680 --> 00:18:19.720 mechanism. It's the how the specific channels 00:18:19.720 --> 00:18:21.460 through which a central bank's policy change 00:18:21.460 --> 00:18:23.859 affects the broader economy. And the first most 00:18:23.859 --> 00:18:26.180 direct channel is investment behavior. Right. 00:18:26.279 --> 00:18:28.440 If a central bank raises rates, it increases 00:18:28.440 --> 00:18:31.099 the cost of borrowing for companies. This immediately 00:18:31.099 --> 00:18:33.819 raises the opportunity cost of investing in new 00:18:33.819 --> 00:18:36.200 projects like a new factory or more research. 00:18:36.720 --> 00:18:38.740 So they run the numbers on a project, and because 00:18:38.740 --> 00:18:41.420 the cost of capital is now higher, the expected 00:18:41.420 --> 00:18:43.839 return might not be worth it anymore. Precisely. 00:18:43.880 --> 00:18:46.599 They use a model called net present value, or 00:18:46.599 --> 00:18:50.259 NPV. A higher interest rate acts as a higher 00:18:50.259 --> 00:18:53.019 discount rate on future profits, making those 00:18:53.019 --> 00:18:56.079 future profits look less valuable today. If the 00:18:56.079 --> 00:18:59.180 NPV of a project drops below zero, the company 00:18:59.180 --> 00:19:01.799 scraps it. So by lowering rates, the central 00:19:01.799 --> 00:19:04.500 bank lowers that bar, making more projects look 00:19:04.500 --> 00:19:07.150 profitable and stimulating investment. the second 00:19:07.150 --> 00:19:10.029 channel is the asset price or wealth effect this 00:19:10.029 --> 00:19:13.109 one is huge rate changes directly affect the 00:19:13.109 --> 00:19:15.349 prices of stocks and houses okay how does that 00:19:15.349 --> 00:19:18.170 work when rates fall Future corporate profits 00:19:18.170 --> 00:19:20.470 are discounted less, which tends to drive up 00:19:20.470 --> 00:19:23.190 stock prices. At the same time, lower mortgage 00:19:23.190 --> 00:19:25.349 rates make housing more affordable, increasing 00:19:25.349 --> 00:19:27.289 demand and pushing up house prices. And this 00:19:27.289 --> 00:19:29.910 creates the wealth effect. Exactly. When people 00:19:29.910 --> 00:19:32.329 see their 401k and the value of their home going 00:19:32.329 --> 00:19:34.769 up, they feel wealthier. And that feeling of 00:19:34.769 --> 00:19:36.950 security encourages them to save a little less 00:19:36.950 --> 00:19:39.170 and spend a little more, which is a massive driver 00:19:39.170 --> 00:19:41.630 of the economy. The third major channel involves 00:19:41.630 --> 00:19:43.670 international differentials. This is about exchange 00:19:43.670 --> 00:19:46.529 rates and trade. If the U .S. raises its interest 00:19:46.529 --> 00:19:49.730 rates relative to, say, Europe, international 00:19:49.730 --> 00:19:52.230 capital will flow into the U .S. to chase that 00:19:52.230 --> 00:19:54.609 higher return. Which increases demand for the 00:19:54.609 --> 00:19:57.450 U .S. dollar, making it stronger. And a stronger 00:19:57.450 --> 00:19:59.750 dollar makes U .S. exports more expensive for 00:19:59.750 --> 00:20:01.849 other countries while making imports cheaper 00:20:01.849 --> 00:20:05.349 for Americans. This directly impacts net exports, 00:20:05.490 --> 00:20:08.650 exports minus imports, which is another core 00:20:08.650 --> 00:20:10.910 piece of the economy. So all these things, investment. 00:20:11.549 --> 00:20:13.829 consumption driven by wealth and net exports. 00:20:14.130 --> 00:20:16.549 They are the building blocks of what economists 00:20:16.549 --> 00:20:19.549 call aggregate demand. And by steering that demand, 00:20:19.769 --> 00:20:22.710 monetary policy affects national output and eventually 00:20:22.710 --> 00:20:24.789 employment levels. And that ties into the famous 00:20:24.789 --> 00:20:27.329 Phillips curve connection, the idea of a tradeoff 00:20:27.329 --> 00:20:30.049 between unemployment and inflation. In theory, 00:20:30.089 --> 00:20:33.079 yes. As you stimulate demand and push unemployment 00:20:33.079 --> 00:20:36.299 down, the labor market tightens. Companies have 00:20:36.299 --> 00:20:38.660 to pay higher wages to attract workers, and they 00:20:38.660 --> 00:20:40.859 pass those higher costs on to consumers in the 00:20:40.859 --> 00:20:43.359 form of higher prices, which creates inflation. 00:20:43.680 --> 00:20:45.299 But that relationship has gotten a bit blurry 00:20:45.299 --> 00:20:47.539 in recent years, hasn't it? It's become much 00:20:47.539 --> 00:20:49.759 more complex. We've seen periods of very low 00:20:49.759 --> 00:20:52.119 unemployment without the expected jump in inflation, 00:20:52.400 --> 00:20:54.519 which has made the job of central bankers much 00:20:54.519 --> 00:20:56.759 harder. Now, let's bring this back to the individual. 00:20:57.230 --> 00:21:00.150 One of the biggest concerns today is how all 00:21:00.150 --> 00:21:03.609 this affects our savings and pensions. The sources 00:21:03.609 --> 00:21:06.190 highlight this really unusual period from about 00:21:06.190 --> 00:21:10.069 1982 to 2012, where we had this great combination 00:21:10.069 --> 00:21:13.250 of low inflation but pretty high returns on assets, 00:21:13.450 --> 00:21:15.970 especially bonds. And this created a sort of 00:21:15.970 --> 00:21:18.690 dangerous complacency for pension funds. It did. 00:21:18.970 --> 00:21:21.390 Pension consultants made these very optimistic 00:21:21.390 --> 00:21:23.910 assumptions. They figured they could get, say, 00:21:24.130 --> 00:21:27.369 a six percent long term return, which meant they 00:21:27.369 --> 00:21:29.650 didn't need to hold as much cash today to cover 00:21:29.650 --> 00:21:32.009 their promises for 30 years from now. But the 00:21:32.009 --> 00:21:35.339 era. of 0RP and NIRP completely upended that 00:21:35.339 --> 00:21:37.660 map. It was devastating for them. Here's why. 00:21:38.380 --> 00:21:40.779 A pension's liabilities, the payments it owes 00:21:40.779 --> 00:21:43.359 to future retirees, have to be discounted back 00:21:43.359 --> 00:21:45.920 to today's value. Using the current risk -free 00:21:45.920 --> 00:21:48.480 interest rate. Exactly. So when rates are high, 00:21:48.640 --> 00:21:51.200 that future liability has a small present value. 00:21:51.880 --> 00:21:53.759 But when interest rates are pushed down near 00:21:53.759 --> 00:21:57.119 zero, the discount rate falls. And the calculated 00:21:57.119 --> 00:21:59.859 present value of that same future promise just 00:21:59.859 --> 00:22:02.880 skyrockets. All of a sudden, the fund looks massively 00:22:02.880 --> 00:22:06.049 underfunded. Wow. So a decade of low rates acted 00:22:06.049 --> 00:22:09.250 like this silent, brutal accounting force on 00:22:09.250 --> 00:22:11.230 these funds. And the problem for the individual 00:22:11.230 --> 00:22:14.490 saver is the same. Without returns that can significantly 00:22:14.490 --> 00:22:17.009 beat inflation, the real value of your nest egg 00:22:17.009 --> 00:22:19.930 is shrinking, not growing. The interest you get 00:22:19.930 --> 00:22:22.529 in a basic savings account today often doesn't 00:22:22.529 --> 00:22:24.890 even keep pace with inflation. This whole discussion 00:22:24.890 --> 00:22:27.329 about charging interest or earning so little 00:22:27.329 --> 00:22:29.869 you lose money, it raises this fascinating philosophical 00:22:29.869 --> 00:22:33.190 counterpoint. the idea of an interest -free economy. 00:22:33.430 --> 00:22:35.710 It sounds radical, but the source defines it 00:22:35.710 --> 00:22:37.750 in a very specific way. It's an economy without 00:22:37.750 --> 00:22:40.710 a pure, risk -free interest rate component. And 00:22:40.710 --> 00:22:43.329 historically, this isn't that radical. Many cultures 00:22:43.329 --> 00:22:45.789 and religions, including Islam and aspects of 00:22:45.789 --> 00:22:48.309 Christianity, have had strong taboos against 00:22:48.309 --> 00:22:50.990 usury. So a normal interest rate has four parts. 00:22:51.450 --> 00:22:55.210 Pure interest, a risk premium, inflation compensation, 00:22:55.670 --> 00:22:58.509 and administrative costs. In an interest -free 00:22:58.509 --> 00:23:01.130 model, only that first part, the pure interest, 00:23:01.349 --> 00:23:03.410 the charge just for the privilege of borrowing, 00:23:03.670 --> 00:23:06.269 is removed. So banks could still operate and 00:23:06.269 --> 00:23:08.150 make a profit? Oh, absolutely. They would just 00:23:08.150 --> 00:23:10.369 have to make their money from the other components. 00:23:10.470 --> 00:23:12.950 They could charge for administrative costs, or 00:23:12.950 --> 00:23:14.769 they could enter into profit -sharing agreements 00:23:14.769 --> 00:23:16.990 with the borrower. It's a different framework, 00:23:17.170 --> 00:23:20.230 one that's focused on sharing the risks and rewards 00:23:20.230 --> 00:23:22.750 of actual economic activity rather than just 00:23:22.750 --> 00:23:25.289 charging for time. Okay. We've covered the central 00:23:25.289 --> 00:23:28.160 bank's hammer. But let's hit specific. If the 00:23:28.160 --> 00:23:31.079 Fed sets a target rate, what determines the actual 00:23:31.079 --> 00:23:33.119 rate you get on your mortgage or your car loan? 00:23:33.460 --> 00:23:36.799 This is Section 5, the dynamics of private markets. 00:23:37.019 --> 00:23:39.440 This is where we go from macro policy to micro 00:23:39.440 --> 00:23:42.039 pricing. The rate you see is built in layers, 00:23:42.059 --> 00:23:44.680 all on top of that base risk -free rate from 00:23:44.680 --> 00:23:46.299 the central bank. And the sources break this 00:23:46.299 --> 00:23:48.980 down into four key components. The risk -free 00:23:48.980 --> 00:23:52.099 rate, expected inflation, a risk premium, and 00:23:52.099 --> 00:23:54.740 transaction costs. The interplay between those 00:23:54.740 --> 00:23:57.839 is why your credit card rate can be 24 % while 00:23:57.839 --> 00:24:00.819 a government bond might yield 4%. So let's look 00:24:00.819 --> 00:24:03.660 at the factors driving those components. First 00:24:03.660 --> 00:24:06.680 is deferred consumption. Just the basic human 00:24:06.680 --> 00:24:08.940 preference for having things now rather than 00:24:08.940 --> 00:24:12.299 later. Lenders have to be compensated for delaying 00:24:12.299 --> 00:24:15.259 their own gratification. Second, inflationary 00:24:15.259 --> 00:24:17.579 expectations, which we know from the Fisher equation. 00:24:18.119 --> 00:24:20.720 Lenders need to be protected from their money 00:24:20.720 --> 00:24:23.430 losing value over time. And it's important how 00:24:23.430 --> 00:24:25.950 those expectations are formed. The sources distinguish 00:24:25.950 --> 00:24:28.970 between rational expectations, where everyone 00:24:28.970 --> 00:24:31.710 perfectly predicts inflation. Which never happens. 00:24:31.890 --> 00:24:34.470 Right. And behavioral expectations, which is 00:24:34.470 --> 00:24:36.890 much more realistic. It says people use shortcuts. 00:24:37.230 --> 00:24:38.990 They're slow to update their beliefs. They have 00:24:38.990 --> 00:24:41.549 blind spots. And that really matters for policy, 00:24:41.750 --> 00:24:44.009 because if people aren't updating their expectations 00:24:44.009 --> 00:24:46.589 quickly, the central bank might have to be much 00:24:46.589 --> 00:24:48.450 more aggressive with its rate changes to get 00:24:48.450 --> 00:24:50.660 the desired effect. Then you have alternative 00:24:50.660 --> 00:24:53.460 investments. A lender can put their money anywhere. 00:24:53.940 --> 00:24:56.799 By lending it to you, they're giving up the chance 00:24:56.799 --> 00:24:59.200 to invest in stocks or real estate. So all these 00:24:59.200 --> 00:25:01.539 investments have to compete for capital, which 00:25:01.539 --> 00:25:03.980 drives up the required return. And don't forget 00:25:03.980 --> 00:25:07.019 taxes. If your interest earnings are taxed, you'll 00:25:07.019 --> 00:25:09.119 demand a higher rate up front to make sure your 00:25:09.119 --> 00:25:11.660 after -tax return is still worth it. There's 00:25:11.660 --> 00:25:13.799 also one other factor, a more political one. 00:25:14.000 --> 00:25:17.500 Political short -term gain. It can be very tempting 00:25:17.500 --> 00:25:20.059 for governments to push for lower rates right 00:25:20.059 --> 00:25:22.599 before an election to create a short term economic 00:25:22.599 --> 00:25:25.579 boost. Which is the core argument for why central 00:25:25.579 --> 00:25:27.680 banks need to be independent to insulate them 00:25:27.680 --> 00:25:30.000 from that kind of political pressure. Absolutely. 00:25:30.200 --> 00:25:32.400 But the biggest component, the one that creates 00:25:32.400 --> 00:25:35.579 the most variation, is risk and the risk premium. 00:25:35.900 --> 00:25:38.339 The lender is always taking a risk that you won't 00:25:38.339 --> 00:25:40.519 pay them back. Whether it's an individual filing 00:25:40.519 --> 00:25:43.119 for bankruptcy. or a company going under. So 00:25:43.119 --> 00:25:46.039 the lender, who is generally risk averse, charges 00:25:46.039 --> 00:25:48.779 an extra amount, the risk premium, to compensate 00:25:48.779 --> 00:25:50.960 for those expected losses across their entire 00:25:50.960 --> 00:25:53.740 portfolio of loans. And there's also a maturity 00:25:53.740 --> 00:25:56.559 risk premium, right? A longer loan is seen as 00:25:56.559 --> 00:25:59.819 riskier. It is. So much more can go wrong over 00:25:59.819 --> 00:26:02.980 30 years than over 30 days. So a 30 -year bond 00:26:02.980 --> 00:26:05.240 will almost always have a higher rate than a 00:26:05.240 --> 00:26:07.660 three -month bill to compensate for that long 00:26:07.660 --> 00:26:10.019 -term uncertainty. The sources get really technical 00:26:10.019 --> 00:26:13.259 here. four specific kinds of risk that lenders 00:26:13.259 --> 00:26:16.440 have to price in. Repricing risk, basis risk, 00:26:16.660 --> 00:26:20.240 yield curve risk, and optionality. Let's slow 00:26:20.240 --> 00:26:22.059 down and unpack those. What's repricing risk? 00:26:22.660 --> 00:26:24.940 Repricing risk is the danger that market rates 00:26:24.940 --> 00:26:27.819 change before your loans rate can be reset. Imagine 00:26:27.819 --> 00:26:30.779 a bank gives you a one -year loan at 5%, but 00:26:30.779 --> 00:26:33.519 six months later, the Fed jacks up rates to 7%. 00:26:33.519 --> 00:26:36.759 The bank is stuck earning 5 % while its own costs 00:26:36.759 --> 00:26:38.680 have gone up. They're losing money on that spread. 00:26:38.920 --> 00:26:40.519 Okay, that makes sense. What about basis? Basis 00:26:40.519 --> 00:26:43.339 risk. Basis risk is when two interest rates that 00:26:43.339 --> 00:26:45.460 are supposed to move together suddenly diverge. 00:26:45.480 --> 00:26:48.000 A bank might fund its loans based on one index, 00:26:48.079 --> 00:26:50.180 but price them based on another. If those two 00:26:50.180 --> 00:26:52.839 indexes decouple, their profit margin gets squeezed 00:26:52.839 --> 00:26:55.700 unexpectedly. And yield curve risk. We hear about 00:26:55.700 --> 00:26:57.910 the yield curve inverting all the time. That's 00:26:57.910 --> 00:27:00.549 the risk. A bank's business model is to borrow 00:27:00.549 --> 00:27:06.289 short -term and lend long -term . This works 00:27:06.289 --> 00:27:08.349 when long -term rates are higher than short -term 00:27:08.349 --> 00:27:11.869 rates. If the yield curve inverts, if short rates 00:27:11.869 --> 00:27:14.470 rise above long rates, their entire business 00:27:14.470 --> 00:27:16.890 model breaks down. Their funding costs more than 00:27:16.890 --> 00:27:19.789 their lending earns. And finally, optionality. 00:27:20.089 --> 00:27:22.210 What's that? Optionality is the risk that the 00:27:22.210 --> 00:27:24.289 borrower has an option that benefits them at 00:27:24.289 --> 00:27:26.470 the lender's expense. The classic example is 00:27:26.470 --> 00:27:29.609 prepaying your mortgage. If you have a 7 % mortgage 00:27:29.609 --> 00:27:33.150 and rates drop to 4%, you'll refinance. That's 00:27:33.150 --> 00:27:35.509 great for you. But the bank just lost a high 00:27:35.509 --> 00:27:38.269 -earning asset and now has to reinvest that money 00:27:38.269 --> 00:27:40.950 at a much lower rate. They charge a premium up 00:27:40.950 --> 00:27:43.349 front for that risk. That is a lot of risk to 00:27:43.349 --> 00:27:46.240 price in. But there's one more factor. liquidity 00:27:46.240 --> 00:27:48.319 preference this is just the general preference 00:27:48.319 --> 00:27:50.519 people and companies have for holding cash or 00:27:50.519 --> 00:27:52.640 assets that can be turned into cash quickly and 00:27:52.640 --> 00:27:54.599 easily and this preference is what creates the 00:27:54.599 --> 00:27:58.279 term structure of required returns Exactly. Cash 00:27:58.279 --> 00:28:01.740 is perfectly liquid. Any asset that's less liquid 00:28:01.740 --> 00:28:03.660 has to offer a higher return to convince you 00:28:03.660 --> 00:28:05.940 to tie up your money. A 10 year loan requires 00:28:05.940 --> 00:28:08.400 a bigger liquidity premium than a one year loan 00:28:08.400 --> 00:28:10.720 because your capital is locked up for much longer. 00:28:10.880 --> 00:28:13.220 Although the sources make a great point that 00:28:13.220 --> 00:28:15.799 deep secondary markets like for U .S. Treasury 00:28:15.799 --> 00:28:19.220 bonds can reduce this cost. Even though they 00:28:19.220 --> 00:28:21.400 have long maturities, you can sell them instantly, 00:28:21.640 --> 00:28:23.859 which makes them feel very liquid. That's right. 00:28:24.039 --> 00:28:26.980 So we can put all of this together in a conceptual 00:28:26.980 --> 00:28:30.299 market model. The nominal interest rate, $1, 00:28:30.299 --> 00:28:32.920 is built from these different pieces. Yes. It's 00:28:32.920 --> 00:28:35.480 approximated by the sum of the risk -free rate 00:28:35.480 --> 00:28:38.240 plus expected inflation plus the risk premium 00:28:38.240 --> 00:28:41.170 plus the liquidity premium. So the rate you pay 00:28:41.170 --> 00:28:43.670 is the fundamental price of time, plus protection 00:28:43.670 --> 00:28:46.349 against inflation, plus compensation for the 00:28:46.349 --> 00:28:48.930 risk -guilt default, plus compensation for the 00:28:48.930 --> 00:28:51.569 hassle of tying up the lender's cash. That linear 00:28:51.569 --> 00:28:54.930 approximation $1 plus PT plus RP plus LPP is 00:28:54.930 --> 00:28:58.089 a great mental shortcut. The actual math is multiplicative 00:28:58.089 --> 00:29:00.089 because of compounding, but for most purposes, 00:29:00.150 --> 00:29:02.049 just adding them up gives you the right idea. 00:29:02.309 --> 00:29:04.990 And finally, inside the banking system itself, 00:29:05.289 --> 00:29:07.950 there's the concept of the spread. The interest 00:29:07.950 --> 00:29:10.509 rate spread is just the lending rate the bank 00:29:10.509 --> 00:29:13.250 charges minus the deposit rate it pays to savers. 00:29:13.509 --> 00:29:16.089 That gap is how the bank covers all its operating 00:29:16.089 --> 00:29:18.809 costs and makes a profit. It's their entire engine. 00:29:18.970 --> 00:29:22.269 It is. You can very rarely see a negative spread 00:29:22.269 --> 00:29:24.809 where a bank pays more on deposits than it earns 00:29:24.809 --> 00:29:27.470 on loans. But that usually only happens in very 00:29:27.470 --> 00:29:29.470 distorted markets or during a panic where they're 00:29:29.470 --> 00:29:32.740 desperate for cash. Wow. We have taken a huge 00:29:32.740 --> 00:29:35.039 journey. We've traced the interest rate from 00:29:35.039 --> 00:29:37.440 a philosophical idea, the price of time, all 00:29:37.440 --> 00:29:40.400 the way to a macroeconomic lever of immense power 00:29:40.400 --> 00:29:43.640 and then down to a granular four part pricing 00:29:43.640 --> 00:29:45.599 formula. We really have. We started with the 00:29:45.599 --> 00:29:48.440 basic definition and the absolute necessity of 00:29:48.440 --> 00:29:50.619 using the Fisher equation to understand the real 00:29:50.619 --> 00:29:52.819 rate, the one that affects your actual buying 00:29:52.819 --> 00:29:55.099 power. We then explored how central banks use 00:29:55.099 --> 00:29:58.240 policy rates, noting the insane historical volatility 00:29:58.240 --> 00:30:00.670 from 800 percent in hyperinflation. inflationary 00:30:00.670 --> 00:30:03.130 Zimbabwe to the financial repression of the post 00:30:03.130 --> 00:30:05.990 -war era when U .S. treasuries became those so 00:30:05.990 --> 00:30:08.569 -called certificates of confiscation. And we 00:30:08.569 --> 00:30:10.730 spent a lot of time on the radical modern policies 00:30:10.730 --> 00:30:14.710 of ZIRP and NIRP, seeing how the theory for negative 00:30:14.710 --> 00:30:17.170 rates goes all the way back to Silvio Ghisel's 00:30:17.170 --> 00:30:20.130 idea of a tax on holding money and how that theory 00:30:20.130 --> 00:30:22.950 became reality in Japan and Europe. We then connected 00:30:22.950 --> 00:30:25.289 those rates to the real world through the monetary 00:30:25.289 --> 00:30:27.750 transmission mechanism, detailing how they affect 00:30:27.750 --> 00:30:29.970 corporate investment, create the household wealth 00:30:29.970 --> 00:30:32.730 effect and impact trade through exchange rates. 00:30:33.029 --> 00:30:35.470 And finally, we broke down that private market 00:30:35.470 --> 00:30:38.029 model, showing how your specific rate... is built 00:30:38.029 --> 00:30:40.230 piece by piece, incorporating the risk -free 00:30:40.230 --> 00:30:42.849 rate, inflation, your personal risk premium, 00:30:43.029 --> 00:30:46.009 and the lender's need for liquidity. What's the 00:30:46.009 --> 00:30:48.109 one thing that really stands out to you in conclusion, 00:30:48.289 --> 00:30:50.470 thinking about where this number has been and 00:30:50.470 --> 00:30:52.609 the politics behind it? It's that the history 00:30:52.609 --> 00:30:55.130 here shows very clearly that governments will 00:30:55.130 --> 00:30:58.190 use extreme measures to manage their debt. The 00:30:58.190 --> 00:31:01.009 lesson of financial repression is powerful. A 00:31:01.009 --> 00:31:03.890 government can and will use negative real interest 00:31:03.890 --> 00:31:06.910 rates as a stealthy way to transfer wealth from 00:31:06.910 --> 00:31:09.349 savers to the state to reduce its debt burden. 00:31:09.549 --> 00:31:11.829 And now we've seen them use negative nominal 00:31:11.829 --> 00:31:15.549 rates, NIRP, to explicitly change our mindset, 00:31:15.710 --> 00:31:18.569 to penalize saving and force spending. It's a 00:31:18.569 --> 00:31:20.630 deliberate act of financial engineering. Which 00:31:20.630 --> 00:31:22.910 leaves us with this incredibly important final 00:31:22.910 --> 00:31:25.069 thought, something for you, the listener, to 00:31:25.069 --> 00:31:28.180 really mull over. If NIRP is designed to put 00:31:28.180 --> 00:31:31.240 a cost on holding money to push you out of cash 00:31:31.240 --> 00:31:34.039 and into spending or physical assets, what is 00:31:34.039 --> 00:31:36.660 the ultimate theoretical limit? How deeply negative 00:31:36.660 --> 00:31:39.660 could rates actually go? At what point does society 00:31:39.660 --> 00:31:42.339 just reject the concept of money as a store of 00:31:42.339 --> 00:31:45.039 value? Exactly. If the reward for saving becomes 00:31:45.039 --> 00:31:47.500 a guaranteed loss, would we eventually just abandon 00:31:47.500 --> 00:31:50.079 money and prefer physical assets? Or could we, 00:31:50.140 --> 00:31:52.640 following Gassel's logic to its conclusion, even 00:31:52.640 --> 00:31:55.039 turn back toward an interest -free economy based 00:31:55.039 --> 00:31:57.539 on shared profits? just to escape the confiscatory 00:31:57.539 --> 00:32:00.220 nature of extreme negative returns. The interest 00:32:00.220 --> 00:32:02.279 rate, then, is not just a number on a statement. 00:32:02.519 --> 00:32:05.380 It is a mechanism of historical power, deeply 00:32:05.380 --> 00:32:07.440 tied to human behavior, political necessity, 00:32:07.680 --> 00:32:10.339 and the entire structure of our markets. That 00:32:10.339 --> 00:32:12.819 was an intense and surprisingly dramatic deep 00:32:12.819 --> 00:32:15.240 dive. Indeed. We look forward to diving in again 00:32:15.240 --> 00:32:15.500 soon.