More About Forecasting Interest Rates

One does not have to be an expert to try and predict the course of interest rates. An understanding of the important variables that determine interest rates will help the investor make an informed judgement.

Perhaps the key variable for interest rates in the short term is "monetary policy". This is the policy that governments implement by altering the "money supply", the amount of money available in a country. While there are many arguments about the importance of money supply and what constitutes money in a modern economy, there can be no doubt that restricting money supply leads to higher interest rates and adding to the money supply lowers rates, all other things being equal. The economic term for this is "liquidity". When there is a lot of money available, monetary policy is said to be "loose" or the economy and markets to be "very liquid". When money is restricted or scarce, policy is said to be "tight" or the economy and markets "illiquid".

The central banks, for example The Bank of Canada, alter monetary policy to keep the economy and inflation on a steady course. When the economy is very strong and unemployment low, a central bank will tighten monetary policy to prevent an "inflationary spiral" as wages and prices are bid up. In a recession, a central bank will loosen monetary policy to "stimulate growth" as the economy can afford to speed up given high unemployment and low wage and price pressure.

Inflation is important to interest rates, as investors in fixed rate bonds demand a return above inflation for lending their funds as inflation eats away at their capital. If investors think inflation will be high or rising, they will sell bonds and this will make longer-term interest rates rise. If monetary policy is very loose over the longer term, it results in high inflation as is the case in Brazil and Israel, which have historically experienced very high rates of monetary growth and inflation.

The demand for capital is important for interest rates as well. If many borrowers want to borrow money and the "demand for funds" is high, then the price of borrowing money will go up, leading to increasing interest rates, everything else being equal. If there are few borrowers, the demand for borrowing will be low and lenders will drop the price they charge for lending their funds, hence there is downward pressure on interest rates. This can be seen easily by the behaviour of lenders in the residential mortgage market. When real estate is booming and there is a high demand for mortgages, it is hard to strike a deal at a lower rate than the posted rate. This was the case in the late 1980s, with a booming housing market, booming economy and restrictive monetary policy. In the 1990s with a comatose housing market, severe recession and loose monetary policy, lenders competed with low rates and "mortgage specials".

There are many other factors which affect the long- and short-term course of interest rates, including demographics, political trends and institutions, and social values. In Japan, for example, traditionally not a "consumer" or "credit" society, interest rates tend be lower as fewer people borrow to make consumer purchases and the level of savings is very high.

In summary, nobody really can predict the course of interest rates with a high level of accuracy. If the economy is weak, monetary policy loose and inflation low, interest rates are likely to be low and falling. If the economy is "overheated", monetary policy tight and inflation rising, interest rates are likely to be high and rising.

Just one economist's trick to remember: "if you hold on to your forecast long enough, you're bound to be right!" Of course, as economists also say: "in the long-term we're all dead!"

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