The Interference in the Money Market by the Central Bank Completely Changes the Process of Interest Rate Formation

Some economists argue that it is not the central bank but market participants who determine longer term credit rates. This view is influenced by the classical economic theory where the interest rate equilibrates saving and investment. As argued above, without interference from the outside, the market rate may well converge to the natural rate which equilibrates saving and investment. But the interference in the money market by the central bank completely changes the process of interest rate formation. Now it is no longer the preferences of market participants but the expected action of the central bank that is pivotal in the formation of interest rates. But can the central bank not derive the natural interest rate by carefully analyzing economic developments? Unfortunately, no model designed by an economist is capable of capturing the cumulated knowledge in the heads of all economic actors needed to calculate the correct natural interest rate. It can only emerge from their exchange in the market. Hence, despite their technical refinements, all the models used by central banks to steer the market rate to the natural rate must be inadequate and lead to errors in interest rate formation.

—Thomas Mayer, Austrian Economics, Money and Finance, Banking, Money and International Finance 8 (London: Routledge Taylor & Francis Group, 2018), 68-69.