Bonds: mechanism to set floor interest rate

[CA PP]

hi moda,

on an other post you refer to bonds as a tool to set floor interest rates.

i am very much interested to understand that mechanism a play.  could you please elaborate a bit on the mechanics of that?  it would really help underrstand why bonds exists, something i currently do not grasp in a fiat economy?

thanks in advance.

[moda0306]

Bonds are simply a contract detailing one entity borrowing money to another for a price.  An issuer of a fiat currency has no need to issue bonds to procure funds, though the US chooses to continue to engage the market.

In reality, if a fiat currency issuer is still issuing bonds, and people/banks believe those bonds to be risk free in nominal terms, this will set a floor in the private sector as to what interest rate people will lend to others at.  Why would I ever lend to you or any other entity for less than I lend to the federal government?

What this does is allows the government to control over-zealous investment and inflation by the private lending mechanisms, since they're not really constrained by any true monetary reserve the way they were under the gold standard. 

Does that all make sense?

[Pointedstick]

Specifically regarding being a floor on interest rates:

Suppose a government issues a 1-month bond at 5% interest. What bank or corporation could possibly sell a CD or bond for any duration at, say, 4%? Or 3%? Nobody would buy them, preferring the government bond instead. This is because during normal times, the government bond is always the most desirable one due to its safety compared to private sector interest-bearing investments. Why? Because you are guaranteed your money by an entity with the power to tax and conjure money out of thin air.

No matter what you may think of these practices, this nonetheless makes for a very safe and predictable market for bond investors. A fiat currency controlling government never lacks the ability to pay; only perhaps the will.

[Libertarian666]

Specifically regarding being a floor on interest rates:

Suppose a government issues a 1-month bond at 5% interest. What bank or corporation could possibly sell a CD or bond for any duration at, say, 4%? Or 3%? Nobody would buy them, preferring the government bond instead. This is because during normal times, the government bond is always the most desirable one due to its safety compared to private sector interest-bearing investments. Why? Because you are guaranteed your money by an entity with the power to tax and conjure money out of thin air.

No matter what you may think of these practices, this nonetheless makes for a very safe and predictable market for bond investors. A fiat currency controlling government never lacks the ability to pay; only perhaps the will.

In nominal terms, that is correct. They may lack the ability to pay in real terms, however, and in fact that is almost always the end game of fiat currency.
So government bonds are not in fact riskless even when they can print money.

[moda0306]

Tech,

I'm sorry if we weren't clear.  Government bonds very definitely have exposure in real terms. Not even a question.  Only in nominal terms are they risk-free. All folks should know, and many do, that all government bonds are is a piece of paper that is a future claim on a piece of paper. There is absolutely inflation risk.

[CA PP]

thanks for answers.

interest rates are function of demand/offer and gov has a large control on offer of liquidity, effectively influencing short term rate?

how can we explain existence of bonds with longer maturities? 5years +.

thanks.

[moda0306]

TennPaGa,

I have to disagree with part of that.  I think the fed controls long term rates mostly through expectations of future short term rates, not directly by buying long term treasuries... Which obviously flies in the face of what the treasury has done, but I just simply don't think there could be any other driver.

I think when the fed buys long bonds, it's almost more of what a military parade is to actual military mobilization.

There is an inflation driver in there, but only to the extent inflation will drive the Fed's decisions to raise rates.

[CA PP]

many thanks for answers and the link.