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Interest Rate: Indicators for Rise/Fall

In forming a view on the future course of interest rates, it is necessary to recognise that changes in monetary policy interest rate settings are likely to affect the state of the economy, which in turn affects interest rates generally. For example, when a policy-induced increase in interest rates causes a reduction in the pace of economic growth, the demand for funds begins to decline and the rate of interest begins to ease. Furthermore, there is likely to be an accompanying reduction in the rate of inflation, thus causing interest rates to fall further. Within the macroeconomic context, these progressive changes are referred to as the ‘liquidity effect’, ‘income effect’ and ‘inflation effect’ on interest rates.

A more disciplined approach to forming a view on the future of interest rates is provided by the ‘loanable funds’ (LF) approach. In this approach, the supply of loanable funds is identified as being determined by the savings of the household sector, changes in the money supply, and the hoarding/dishoarding, or portfolio reallocations, which take place in response to changes in the rate of interest. The demand for funds originates from the business and government sectors. The prevailing rate of interest is the rate that equates the demand for and supply of loanable funds. Factors that cause the demand or supply to change will result in a change in the rate of interest. While the framework is useful in identifying impacts on interest rates, its major shortcoming is that the supply and demand curves are interdependent. As a result it is not possible to determine a unique equilibrium interest rate.

One of the other shortcomings of the LF approach is that is addresses interest rate determination as if only one interest rate exists at a particular time. This is clearly not the case in reality. At any point there is a great multitude of rates. The differences in rates reflect the different terms to maturity of the instruments and the credit risk of the borrower. Differences between the rates on instruments of similar risk but with different terms to maturity have been explained by theories of the yield curve.

One approach, the ‘pure expectations’ theory, argues that in efficient markets, the rates on longer-term instruments are determined by the current short-term interest rate, and by the short-term rates that are expected to prevail throughout the life of the longer-term instrument. A variation to this theory is obtained is obtained by the inclusion of a liquidity premium. The liquidity premium hypothesis contends that a loss of liquidity, which exists in longer-term investments, represents an increased risk, and, as such, investors will require a higher return, or a liquidity premium.

The ‘segmented markets’ approach provides an alternative explanation of the shape of the yield curve. It hypothesises that investors do not view bonds of different maturities as being close substitutes. Furthermore, it is argued that investors will have a preference for one of predominantly short-term, medium-term or long-term bonds. The implication of these two arguments is that the shape of the yield curve is explained by the demand and supply conditions in the various maturity segments of the market. While the arguments of the segmented markets hypothesis are appealing, it is flawed because it tends to ignore the role of arbitrageurs and speculators in ensuring that the yield curve over the maturity spectrum remains in equilibrium. As a result the forecasts derived from this approach must be treated with caution.

The other element that has to be considered in explaining the range of interest rates that are available at any one moment is the default of credit risk of the borrower. Higher-risk borrowers must pay a higher rate of return than would be required of lower-risk borrowers.

Finally, the yield curve evident within the financial markets for a particular security will change in its shape and sloe from time to time. A particular security will change in its shape and slope from time to time. A ‘normal’ yield curve is an upward-sloping curve where there is an expectation that short-term interest rates in the future will rise. A steeper normal curve may indicate an expectation that the rate of inflations will increase into the future. An ‘inverse’ yield curve is a downward-sloping curve, typically induced through a tightening of monetary policy by the Reserve Bank. It indicates that current short-term interest rates are high, but that there is an expectation that in the future there will be an easing of monetary policy, and short-term interest rates will fall.