Commerce Degree Topic: Interest Rate Determination

If you read any kind of financial news, you will invariably come across some news about interest rate predictions. This is quite an important part of finance for obvious reasons – interest rates can wildly change portfolio returns, debt repayments of companies, investment of companies and a whole range of other things.

But how do we determine interest rates? When we model investments, can we predict what the interest rate will be at a date in the future? Of course we can’t do this precisely, but there are a few tools that we can use to help us out.

First, however, we need to understand the context in which we are determining these interests rates.

Macroeconomic Context

The Reserve Bank adjusts its monetary policy in order to keep the inflation rate between 2 and 3 percent. However, one of the tools it can use to do this is the interest rates.

The interest rate is the cost of money, essentially, and the Reserve Bank can adjust its cost of money to influence the interest rates that are offered by consumer banks both in the short and in the long term. While it is not super important for our purposes to understand exactly how they do this, it is important to understand why.

The Reserve Bank may increase interest rates if:

  1. Inflation is above target range
  2. the is excessive growth in GDP
  3. There is a large deficit in the balance of payments
  4. rapid growth in credit and debt levels
  5. excessive downward pressure on FX markets

An increasing of interest rates makes money more expensive, and therefore reduces the amount of money in the economy. For this reason, it is called a tightening of monetary policy.

There are three main effect of the interest rates going up. The first is that eventually, long term interest rates will go up. With the rates on loans and credit cards going up, consumers will spend less which reduces inflation and the demand for imports. Finally, a higher interest rate environment may attract foreign investors, causing worldwide demand for the domestic currency and appreciating the domestic currency.

When we understand these effects, we can look at some of the more general effects of the interest rate change.

Liquidity Effect

When interest rates are increase, the Reserve Bank essentially sells its own securities into the market. This effectively takes money out of the market, and decreases liquidity. The opposite is true if the the interest rates are decreased.

Income Effect

When interest rates go up, and there is less money in the economy, people’s income will decrease. This slows their spending, and actually allows the interest rates to ease.

Inflation Effect

As people purchase less, the demand for loans slows, which means less money is needed in the economy. This reduces the rate of inflation, which is why the Reserve Bank increased interest rates in the first place.

 

When we are trying to predict interest rate movements, we can use different economic indicators. Some of these will lead changes in the business cycle, some will happen with the business cycle, and others will lag the changes in the business cycle. If we are able to use the indicators effectively, we may be able to predict the Reserve Bank’s intervention.

 

Loanable Funds Method

The loanable funds method if the preferred way by financial market analysts to predict interest rate movements, and is quite a simplistic model. We begin with two assumptions.

  1. As interest rates rise, the demand for funds falls
  2. As interest rates rise, the supply of funds increases

We also break the demand for funds into two sectors:

  1. Business demand for funds (B)
  2. Government demand for funds (G)

Therefore, our demand for loanable funds is equal to B + G

Our supply of loanable funds is also split into three sectors:

  1. Savings of the household sector (S)
  2. Changes in the money supply (M)
  3. Dishoarding (D)

Hoarding is the amount of savings held as currency. Dishoarding occurs when interest rates rise and more securities are purchased for the higher yield that is available.

When we plot the supply and demand curves for the loanable funds, we find that they are not independent, and will change. This is mainly due to dishoarding occurring as interest rates change.

Term Structure of Interest Rates

A yield curve that plots the yield on an identical security with different terms to maturity.

If the yield curve is upward sloping, it means that rates in the future are higher than current rates, while the opposite is true for a downward sloping yield curve. We may also encounter yield curves that change from upward sloping to downward sloping.

The fact that yield curves change over time tells us that monetary policy is not the only factor changing interest rates. So, we have three theories to try and explain the shape of the yield curve.

  1. Expectations Theory
  2. Market Segmentation Theory
  3. Liquidity Premium Theory

Expectations Theory

The expectations theory is relatively simple. It says that we forecast rates on a short term basis, and long term rates are an average of those short term forecasts.

For example, if we forecast the rates for one year ahead now, and in one year, then the two year interest rate starting now will be the average of the two. However, for this to work, we need to start with the following assumptions:

  1. Large number of investors with reasonably homogeneous expectations
  2. No transaction costs and no impediments to interest rates moving to their competitive equilibrium levels
  3. Investors aim to maximise returns and view all bonds as perfect subsitutes regardless of term to maturity

Segmented Market Theory

This directly challenges the third assumption of the expectations theory and says that bonds with different maturity levels are imperfect substitutes. It also rejects the assumption that investors aim to maximise returns and instead assumes tht investors aim to minimise their risk.

This then operates as you would expect, by increasing interest rates relative to where funds are being demanded. So, if the Reserve Bank buy a lots of short term securities and sell long term securities, they can increase the average term of bonds, and therefore create an upward sloping yield curve.

Liquidity Premium Theory

Assumes investors prefer short term instruments due to the liquidity, so they require compensation for longer term securities. This premium can be added into the expectations theory by adding a constant liquidity premium term. This will be more significant the further into the future we observe the yield curve. It can also change a curve from downward sloping from upward sloping.

Risk Structure of Interest Rates

This is a simple concept, and essentially says that for riskier bonds, investors require a risk premium  for holding them, meaning that the yield curve will be higher for riskier bonds.

 

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