Financial Markets and Institutions (2-downloads)

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Forecasting Interest Rates

Forecasting interest rates is a time-honored profession. Financial economists are hired (sometimes at very high

salaries) to forecast interest rates because businesses need to know what the rates will be in order to plan their

future spending, and banks and investors require interest-rate forecasts in order to decide which assets to buy.

Interest-rate forecasters predict what will happen to the factors that affect the supply and demand for bonds

and for money—factors such as the strength of the economy, the profitability of investment opportunities, the

expected inflation rate, and the size of government budget deficits and borrowing. They then use the supply-

and-demand analysis we have outlined in this chapter to come up with their interest-rate forecasts.

The

Wall Street Journal reports interest-rate forecasts by leading prognosticators twice a year (early January

and July) on its Web site. Forecasting interest rates is a perilous business. To their embarrassment, even the top

experts are frequently far off in their forecasts.

You can access the interest-rate forecasts at the URL noted below.* In addition to displaying interest-rate

forecast you can see what the leading economists predict for GDP, inflation, unemployment, and housing.

* Go to the book’s Web site 

www.pearsonhighered.com/mishkin_eakins

for the most current URL.

F O L L O W I N G   T H E   F I N A N C I A L   N E W S

bonds for the asset account because, as we have seen in Chapter 3, the drop in inter-

est rates will produce large capital gains. Conversely, if forecasts say that interest rates

are likely to rise in the future, the manager will prefer to hold short-term bonds or

loans in the portfolio in order to avoid potential capital losses on long-term securities.

Forecasts of interest rates also help managers decide whether to borrow long-

term or short-term. If interest rates are forecast to rise in the future, the financial

institution manager will want to lock in the low interest rates by borrowing long-term;

if the forecasts say that interest rates will fall, the manager will seek to borrow short-

term in order to take advantage of low interest-rate costs in the future.

Clearly, good forecasts of future interest rates are extremely valuable to the finan-

cial institution manager, who, not surprisingly, would be willing to pay a lot for accu-

rate forecasts. Unfortunately, interest-rate forecasting is a perilous business, and even

the top forecasters, to their embarrassment, are frequently far off in their forecasts.

S U M M A R Y

1. The quantity demanded of an asset is (a) positively

related to wealth, (b) positively related to the

expected return on the asset relative to alternative

assets, (c) negatively related to the riskiness of the

asset relative to alternative assets, and (d) positively

related to the liquidity of the asset relative to alter-

native assets.

2. Diversification (the holding of more than one asset)

benefits investors because it reduces the risk they

face, and the benefits are greater the less returns on

securities move together.

3. The supply-and-demand analysis for bonds provides

a theory of how interest rates are determined. It pre-

dicts that interest rates will change when there is a

change in demand because of changes in income (or

wealth), expected returns, risk, or liquidity, or when

there is a change in supply because of changes in the

attractiveness of investment opportunities, the real

cost of borrowing, or government activities.

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