An introduction to interest rate determination and forecasting Chapter 13 An introduction to interest rate determination and forecasting

Learning objectives Describe the macroeconomic context of interest rate determination Explain the loanable funds approach to interest rate determination, including supply and demand variables for loanable funds, equilibrium and the effect of changes in variables on interest rates Understand yields, yield curves and term structures of interest rates, and apply the expectations theory, segmented markets theory and liquidity premium theory Explain the risk structure of interest rates and the impact of default risk on interest rates

Chapter organisation 13.1 Macroeconomic context of interest rate determination 13.2 Loanable funds approach to interest rate determination 13.3 Term structure of interest rates 13.4 Risk Structure of interest rates 13.5 Summary

13.1 Macroeconomic context of interest rate determination In most developed economies monetary policy actions are directed at influencing interest rates By understanding what motivates a central bank in its implementation of interest rates policy: financial market participants can anticipate changes in a government’s interest rate policy lenders and borrowers can make better-informed decisions

13.1 Macroeconomic context of interest rate determination (cont.) A central bank may increase interest rates if there is: inflation above target range excessive growth in GDP a large deficit in the balance of payments rapid growth in credit and debt levels excessive ‘downward’ pressure on FX markets

13.1 Macroeconomic context of interest rate determination (cont.) An increase in interest rates (i.e. tightening of monetary policy) will: eventually increase long-term rates slow consumer spending reducing inflation and demand for imports decrease the size of the current account possibly attract foreign investment, causing the domestic currency to appreciate

13.1 Macroeconomic context of interest rate determination (cont.) Three effects of changes in interest rates 1. Liquidity effect The effect of the RBA’s market operations on the money supply and system liquidity E.g. RBA increases rates (i.e. tightens monetary policy) by selling CGSs 2. Income effect A flow-on effect from the liquidity effect If interest rates rise, economic activity will slow, allowing rates to ease Increased rates reduce spending levels and income levels

13.1 Macroeconomic context of interest rate determination (cont.) Three effects of changes in interest rates (cont.) 3. Inflation effect As the rate of growth in economic activity slows, demand for loans also slows This results in an easing of the rate of inflation

13.1 Macroeconomic context of interest rate determination (cont.)

13.1 Macroeconomic context of interest rate determination (cont.) Liquidity, income and inflation effects of changes in interest rates (cont.) It is difficult to forecast the extent of liquidity, income and inflation effects on changes in interest rates Particularly when the business cycle is about to change, i.e. is at a peak or trough Economic indicators provide an insight into possible future economic growth and the likelihood of central bank intervention (cont.)

13.1 Macroeconomic context of interest rate determination (cont.) Economic indicators Leading indicators Economic variables that change before a change in the business cycle Coincident indicators Economic variables that change at the same time as the business cycle changes Lagging indicators Economic variables that change after the business cycle changes (cont.)

13.1 Macroeconomic context of interest rate determination (cont.) Economic indicators (cont.) Difficulties exist with: knowing the extent of the timing lead or lag of such indicators consistently performing indicators, e.g. rates of growth in money measures were once lead indicators and are now lagging indicators

Chapter organisation 13.1 Macroeconomic context of interest rate determination 13.2 Loanable funds approach to interest rate determination 13.3 Term structure of interest rates 13.4 Risk Structure of interest rates 13.5 Summary

13.2 Loanable funds approach to interest rate determination The loanable funds (LF) approach is the preferred way of explaining and forecasting interest rates because it is: preferred by financial market analysts a conceptually simplistic model Alternatively, macroeconomics uses demand and supply of money to explain rates (cont.)

13.2 Loanable funds approach to interest rate determination (cont.) The loanable funds (LF) approach LF are the funds available in the financial system for lending Assumes a downward-sloping demand curve and an upward-sloping supply curve in the loanable funds market; i.e.: as interest rates rise demand falls as interest rates rise supply increases (cont.)

13.2 Loanable funds approach to interest rate determination (cont.) Demand for loanable funds Two sectors 1. Business demand for funds (B) Short-term working capital Longer-term capital investment 2. Government demand for funds (G) Finance budget deficits and intra-year liquidity Demand for loanable funds (B + G) (cont.)

13.2 Loanable funds approach to interest rate determination (cont.)

13.2 Loanable funds approach to interest rate determination (cont.) Supply of loanable funds Comprises three principal sources Savings of household sector (S) Changes in money supply (M) Dishoarding (D) Hoarding is the proportion of total savings in economy held as currency Dishoarding occurs (i.e. currency holdings decrease) as interest rates rise and more securities are purchased for the higher yield available (cont.)

13.2 Loanable funds approach to interest rate determination (cont.)

13.2 Loanable funds approach to interest rate determination (cont.) Equilibrium in the LF market In Figure 13.9 equilibrium is point E and the equilibrium rate is i0 E is a temporary equilibrium because the supply and demand curves are not independent The level of dishoarding will change The money supply is unlikely to increase proportionately in subsequent periods A change in business and/or government demand (cont.)

13.2 Loanable funds approach to interest rate determination (cont.)

13.2 Loanable funds approach to interest rate determination (cont.) Impact of disturbances on rates Expected increase in economic activity Initial effect is that businesses sell securities, yields increase (price decreases), dishoarding occurs Inflationary expectations The demand curve shifts to the right and the supply curve shifts to the left, resulting in higher interest rates and unchanged equilibrium quantity

Chapter organisation 13.1 Macroeconomic context of interest rate determination 13.2 Loanable funds approach to interest rate determination 13.3 Term structure of interest rates 13.4 Risk Structure of interest rates 13.5 Summary

13.3 Term structure of interest rates Yield is the total return on an investment, comprising interest received and any capital gain (or loss) Yield curve is a graph, at a point in time, of yields on an identical security with different terms to maturity (cont.)

13.3 Term structure of interest rates (cont.)

13.3 Term structure of interest rates (cont.) Differently shaped yield curves are evident from time to time Normal or positive yield curve Longer term interest rates are higher than shorter term rates Inverse or negative yield curve Short-term interest rates are higher than longer term rates Humped yield curve Shape of yield curve changes over time from normal to inverse (cont.)

13.3 Term structure of interest rates (cont.) The fact that the shape of the yield curve changes over time suggests that monetary policy interest rate changes are not the only factor affecting interest rates Three theories have been advanced to explain the shape of the yield curve: Expectations theory Market segmentation theory Liquidity premium theory

1. Expectations theory (cont.) The current short-term interest rate and expectations about future short-term interest rates are used to explain the shape and changes in shape of the yield curve Longer term rates will be equal to the average of the short-term rates expected over the period The theory is based on assumptions, e.g.: Large number of investors with reasonably homogenous expectations No transactions costs and no impediments to interest rates moving to their competitive equilibrium levels Investors aim to maximise returns and view all bonds as perfect substitutes regardless of term to maturity (cont.)

Expectations theory (cont.) Example: The rate on a one-year instrument is 7% per annum. The investor expects to obtain 9% per annum on a one-year investment starting in one year’s time. What is the current two-year rate? (cont.)

Expectations theory (cont.) Explanation for the shape of yield curves Inverse yield curve Will result if the market expects future short-term rates to be lower than current short-term rates Normal yield curve Will result from expectations that future short-term rates will be higher than current short-term rates Humped yield curve Investors expect short-term rates to rise in the future but to fall in subsequent periods

2. Segmented markets theory Assumes that securities in different maturity ranges are viewed by market participants as imperfect substitutes (i.e. investors will operate within some preferred maturity range) Rejects two assumptions of the expectations theory Preferences of participants are motivated by reducing the risk of their portfolios; i.e. minimising exposure to fluctuations in prices and yields The shape and slope of the yield curve are determined by the relative demand and supply of securities along the maturity spectrum (cont.)

Segmented markets theory (cont.)

Segmented markets theory (cont.)

Segmented markets theory (cont.) If the central bank increases the average maturity of bonds by purchasing short-term bonds and selling long-term bonds Segmented markets theory suggests: short-term yields decrease and long-term yields increase although financial system liquidity is unchanged, economic activity is affected because areas of expenditure sensitive to: short-term interest rates will expand long-term interest rates will contract Expectations theory suggests: no effect on expectations about future short-term interest rates, and therefore no effect on the economy

Expectations approach versus segmented markets approach The emphasis of the segmented markets theory on risk management denies the existence of investors seeking: arbitrage opportunities without their participation, the extreme segmentation theory would facilitate discontinuities in the yield curve speculative profit speculators’ trading actions are dictated by expectations

3. Liquidity premium theory Assumes investors prefer shorter term instruments, which have greater liquidity and less maturity and interest rate risk and, therefore, require compensation for investing longer term This compensation is called ‘liquidity premium’ (cont.)

Liquidity premium theory (cont.) The liquidity premium can be included in the expectations theory equation L is the size of the liquidity premium (cont.)

Liquidity premium theory (cont.)

Liquidity premium theory (cont.)

Liquidity premium theory (cont.)

Chapter organisation 13.1 Macroeconomic context of interest rate determination 13.2 Loanable funds approach to interest rate determination 13.3 Term structure of interest rates 13.4 Risk Structure of interest rates 13.5 Summary

13.4 Risk structure of interest rates Default risk is the risk that the borrower (i.e. issuer) will fail to meet its interest payment obligations Commonwealth government bonds are assumed to have zero default risk As they are risk-free, they offer a risk-free rate of return Some borrowers may have greater risk of default (i.e. state government or private sector firms) Investors will require compensation for bearing the extra default risk (cont.)

13.4 Risk structure of interest rates (cont.)

13.4 Risk structure of interest rates (cont.)

Chapter organisation 13.1 Macroeconomic context of interest rate determination 13.2 Loanable funds approach to interest rate determination 13.3 Term structure of interest rates 13.4 Risk Structure of interest rates 13.5 Summary

13.5 Summary Changes in monetary policy interest rate settings are likely to affect the state of the economy, which in turn affects interest rates generally This occurs through the liquidity effect, income effect and inflation effect Leading, coincident and lagging economic indicators assist in assessing the direction of the economy, likely future monetary policy actions and the effect on interest rates A more disciplined approach to forming a view on future interest rates is provided by the loanable funds theory (cont.)

13.5 Summary (cont.) The term structure of interest rates is represented by a yield curve, which may be normal, inverse, humped or flat The expectations, segmented markets and liquidity preference theories describe how a yield curve obtains its shape The risk structure of interest rates reflects the level of credit risk, over time, of a particular debt issue