Financial Markets and Institutions (2-downloads)

Profiting from Interest-Rate Forecasts

Given the importance of interest rates, the media frequently report interest-rate fore-

casts, as the Following the Financial News box on page 85 indicates. Because changes

in interest rates have a major impact on the profitability of financial institutions, finan-

cial managers care a great deal about the path of future interest rates. Managers of

financial institutions obtain interest-rate forecasts either by hiring their own staff

economists to generate forecasts or by purchasing forecasts from other financial insti-

tutions or economic forecasting firms.

Several methods are used to produce interest-rate forecasts. One of the most pop-

ular is based on the supply and demand for bonds framework described in this chap-

ter, and it is used by financial institutions such as Salomon Smith Barney, Morgan

Guaranty Trust Company, and the Prudential Insurance Company.

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Using this frame-

work, analysts predict what will happen to the factors that affect the supply of and

demand for bonds—factors such as the strength of the economy, the profitability of

investment opportunities, the expected inflation rate, and the size of government

deficits and borrowing. They then use the supply-and-demand analysis outlined in the

chapter to come up with their interest-rate forecasts. A variation of this approach

makes use of the Flow of Funds Accounts produced by the Federal Reserve. These

data show the sources and uses of funds by different sectors of the American econ-

omy. By looking at how well the supply of credit and the demand for credit by different

sectors match up, forecasters attempt to predict future changes in interest rates.

Forecasting done with the supply and demand for bonds framework often does

not make use of formal economic models but rather depends on the judgment or

“feel” of the forecaster. An alternative method of forecasting interest rates makes use

of econometric models, models whose equations are estimated with statistical pro-

cedures using past data. These models involve interlocking equations that, once input

variables such as the behavior of government spending and monetary policy are

plugged in, produce simultaneous forecasts of many variables including interest rates.

The basic assumption of these forecasting models is that the estimated relation-

ships between variables will continue to hold up in the future. Given this assumption,

the forecaster makes predictions of the expected path of the input variables and then

lets the model generate forecasts of variables such as interest rates.

Many of these econometric models are quite large, involving hundreds and some-

times over a thousand equations, and consequently require computers to produce

their forecasts. Prominent examples of these large-scale econometric models used

by the private sector include those developed by Wharton Econometric Forecasting

Associates and Macroeconomic Advisors. To generate its interest-rate forecasts, the

Board of Governors of the Federal Reserve System makes use of its own large-scale

econometric model, although it makes use of judgmental forecasts as well.

Managers of financial institutions rely on these forecasts to make decisions about

which assets they should hold. A manager who believes that the forecast that long-

term interest rates will fall in the future is reliable would seek to purchase long-term

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Another framework used to produce forecasts of interest rates, developed by John Maynard

Keynes, analyzes the supply and demand for money and is called the liquidity preference framework.

This framework is discussed in a fourth appendix to this chapter, which can be found on the book’s

Web site at 

www.pearsonhighered.com/mishkin_eakins

.

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Chapter 4 Why Do Interest Rates Change?