By Frank Shostak, Mises Wire | January 05, 2026
It is commonly held that the long-term interest rate is an average of current and expected short-term interest rates. The short-term interest rate, it is maintained, is determined by the central bank policy rate, such as the federal funds rate in the US. Hence, it follows that the central bank is the key in the interest rate determination process. But does it make sense that individuals have nothing to do with interest rate determination?
The Interest Rate, Individuals, & Time
According to Carl Menger,
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period…. All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.
Likewise, Ludwig von Mises held,
If he [the consumer] were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the tomorrow would confront him with the same alternative.
It follows from Menger and Mises that an individual must prefer present consumption to identical future consumption. This means that the present consumer goods are at a premium to the future consumer goods. That premium is what the interest is all about.
Consider a case where an individual has just enough goods to keep himself alive. This individual is unlikely to invest or lend his paltry means. The cost of investing or lending to him is very high—it might even cost him his life if he were to consider investing or lending part of his means. Through production, saving, and waiting, the cost of investing or lending is likely to decline.
With an increase in production and saving, the premium of the present goods versus future goods will decline, that is, the interest rate will decline. Conversely, factors that undermine saving are likely to increase the premium of the present goods versus the future goods (i.e., an increase in the interest rate).
Individuals’ responses to changes in savings are not automatic. Every individual, based on his own goals, decides how much to consume and save and when to consume and save. Also, how much to devote to the production of present consumer goods versus the production of future consumer goods.
As a rule, the expansion of savings, individuals tend to allocate more towards the accomplishment of remoter goals in order to improve their quality of life over time. With scarce savings, an individual can only consider very short-term goals, such as direct consumption or making a simple tool. The meager size of his savings does not permit him to undertake the making of more advanced tools. With the increase in savings at his disposal, he could consider undertaking the construction of better tools.
Savings, in turn, permit a further expansion of capital and consumer goods. The expansion of private saving, all other things being equal, permits a greater allocation of savings towards longer-term goals. Prior to the expansion of saving, the necessity to sustain life and well-being in the present made it impossible to embark on various long-term projects. With more saving, this has now become possible. The increased savings can also be invested because the expected future benefits outweigh the benefits of consuming it in the present.
Very few individuals are likely to embark on a business venture, which promises a zero rate of return. The maintenance of the process of life over and above hand-to-mouth existence requires an expansion of production and saving. The expansion implies positive returns.
Now, in a market economy in which a monetary system has developed, interest is expressed in money terms. In the framework of a market-selected money, such as gold, changes in the market interest rate will mirror changes in individuals’ preferences regarding social time preference, that is, the degree of choice between present and future consumption. In the framework of the central bank, which manipulates the money supply and thus the market interest rate, a deviation of the market interest rate from that set by individuals emerges. This deviation is the key factor behind the boom-bust cycles.
Interest Rates Guide Business Decision Makers
In a market economy, changes in interest rates inform businesses about the feasibility of investments and the extent of projects. A decline in the monetary interest rate indicates that individuals have increased their savings which can be channeled toward greater capital investment, which is required for the production of capital goods and, ultimately, the more productive and efficient production of consumer goods. Conversely, an increase in the monetary interest rate implies that less savings are available. A businessman, if he wants to be successful must abide by the market signals as transmitted by consumers, including factoring the interest rate into economic calculation. If a businessman were to ignore the signals, he runs the risk of producing products that consumers assign low priority.
Does the Lowering of the Interest Rates Permit a Greater Capital Goods Production?
What permits an expansion of capital goods production is not the lowering of the interest rates but the increase in voluntary savings. Saving lowers the interest rate and allows a buildup of capital goods. The lowering of the interest rate just mirrors the increase in the allocation of savings towards the capital goods production. The interest rate is just an indicator as it were.
As a rule, the major cause of the discrepancy between the observed interest rate and the free-market interest rate—that would reflect individual time preference to businesses—is central bank monetary policies. The central bank’s artificial lowering of the interest rates takes place in disregard to individuals’ social time preference. The lowering is in response to the central bank policymakers’ view regarding current and future economic conditions.
Now, the lowering of the interest rates here is not because individuals have increased savings. People have not decided to raise their future consumption and thus allocate more savings for this task. Consequently, whenever businesses respond to the central bank’s lowering of the interest rates by investing in capital goods in the future, this diverts savings from the production of goods that are of a higher priority to individuals. The structure of production is distorted.
Hence, whenever the central bank lowers the interest rates through inflationary monetary policy, it disrupts the harmony between the production of present consumer goods and the production of capital goods that are required for the production of future consumer goods. Malinvestment in capital goods emerges. While this malinvestment results in a boom, the liquidation of this malinvestment produces a bust. Hence, the boom-bust economic cycle.
The longer the central bank keeps the interest rates at artificially-low levels via inflation, the greater the damage inflicted towards the wealth-formation process. Consequently, this extends the period of stagnation. We can conclude that it is individuals and not the central bank that determines the interest rates. All that central bank policies do is falsify interest rates and thus distort the signals issued by individuals to businesses.
Conclusion
Contrary to popular thinking, it is individuals and not the central bank that determine interest rates. The central bank monetary policies only falsify market interest rates. Because humans must prefer present consumption to future consumption—otherwise they would die—the interest rate is determined by time preference. In a monetary economy, this is reflected in monetary interest rates, however, interest rates are ultimately determined by individuals and manipulated and distorted by inflation and central banks.
Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor’s degree from Hebrew University, his master’s degree from Witwatersrand University, and his PhD from Rands Afrikaanse University and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.
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