© 2000 John Petroff
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© 2000 John Petroff |
Interest forecasting is closely linked to business cycle forecasting since theories and history of events both show that interest rate changes are not just synchronous with the business cycle, but major causes of changes in borrowing, and therefore, expansions and recessions. Historically, there have been instances of high interest rates during periods of recession, such as 1980 and 1982. But the component that was responsible for this was inflation (linked to oil crisis): one may indeed remember that those were the days of stagflation. This illustrates that forecasting interest rates requires an analysis of each of the six components which were cataloged in Chapter 2 Section D (inflation, non-use of money or investment demand, liquidity preference, time structure, monetary policy, and premium for risk). We can ignore time structure and risk premium as being specific to a particular asset and company, although we are reminded that some strategies (e.g. riding the yield curve described in Chapter 4 Section D-2) specifically focus on these aspects.
To simplify the work further one would be tempted to eliminate inflation since financial decisions ought to be generally made on the basis of real rates, not nominal rates. But inflation actually enters the equation twice:first for the loss of purchasing power of money, and it is also the reason for tight money policy. And tight money policy will definitely raise real interest rates. So, dealing with inflation is unavoidable. Inflation initially defined as a general increase in prices, is traced occasionally to excessive demand (e.g. due to growing disposable income), sometimes to bottlenecks in production or distribution of goods, and often to a pass-through mechanism of costs of production (wages, raw materials or energy). Recently inflation has been looked upon as entirely monetary phenomenon of excessive money creation. Since money creation is what monetary policy is intended to control, the presence of any inflation is a discretionary decision for the central bank authority. Predicting central bank's policy is tricky because of its political ramifications (see Note N-15.1). For Western countries, the size of commercial bank reserves may be indicative of the need for the central bank to act, and forecasting is difficult (but it became easier in the last part of last century when inflation has moderated).
| For countries where central banks are incapable of bringing inflation under control, forecasting is as risky as Russian roulette. In these countries, the major source of high inflation rate is government financing of its budget deficit. While other reasons are sometime presented, such excessive imports and other currency problems, the most important cause is government deficit spending. In such cases, extrapolation of short term trend is the only reasonable alternative, with an adjustment upward if larger budget deficits are anticipated for next year. |
Returning to the last two components of interest rates left, these are compensation for non-use of money (or its mirror image of investment demand) and liquidity preference. These two components are much easier to predict because they correlate with the business cycle very closely. Indeed, as shown in Table T-15.3, in the United States the prime rate is included as a lagging indicator of the business cycle. In Chapter 2 Section D-3, it was shown that liquidity preference is inversely related to velocity of money and interest rates: when people want to spent their money interest rates go up, and when people want to hold on to their money interest rates are depressed. Thus, real interest rates can be forecasted with the same degree of difficulty as business cycles. Times-series analysis and judgmental approach can be used for that purpose. Input-output tables are inappropriate in this case. Econometric models do not seem to be adequate for interest rate forecasting (e.g. in Wharton, Klein-Goldberger and Chase Econometrics interest rates are not really endogenous, but determined by fed's discount rate and banks' excess reserves which are both actual as seen in the example of Section C-1 of this chapter).
See review questions Q-15C6.1 through Q-15C6.9.
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