THE PRACTICING MANAGER
Given the importance of interest rates, the media frequently report interest-rate forecasts, as the Following the Financial News box on page 126 indicates. Because changes in interest rates have a major impact on the profitability of financial institu- tions, financial managers care a great deal about the path of future interest rates.
Managers of financial institutions obtain interest-rate forecasts either by hiring their staff economists to generate forecasts or by purchasing forecasts from other finan- cial institutions or economic forecasting firms.
Several methods are used to produce interest-rate forecasts. One of the most popular is based on the supply and demand for bonds framework described here, and it is used by financial institutions such as Citicorp, Morgan Guaranty Trust
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5Another 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.pearsonglobaleditions.com/Mishkin.
Company, and the Prudential Insurance Company.5 Using this framework, 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 economy. 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 procedures 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 rela- tionships among variables will continue to hold up in the future. Given this assump- tion, 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 uses its own large-scale econo- metric model, although it uses 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 a forecast that long-term interest rates will fall in the future would seek to purchase long-term bonds for the asset account because, as we have seen in Chapter 3, the drop in interest 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 today’s 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.
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S U M M A R Y
1. The theory of portfolio choice tells us that the quan- tity 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) nega- tively related to the riskiness of the asset relative to alternative assets, and (d) positively related to the liquidity of the asset relative to alternative assets.
2. 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.
asset, p. 107
asset market approach, p. 114 demand curve, p. 110 econometric models, p. 125 excess demand, p. 113
excess supply, p. 113 expected return, p. 107 Fisher effect, p. 121 liquidity, p. 107
market equilibrium, p. 113
risk, p. 107
standard deviation, p. 108 supply curve, p. 112
theory of portfolio choice, p. 110 wealth, p. 107
K E Y T E R M S
Q U E S T I O N S
1. Explain the buy, hold, and sell strategies Sam should implement when dealing in BMW shares on the New York Stock Exchange.
2. What are the determinants for an average investor when facing a choice of investing in either properties or shares?
3. Explain the relationship between risk-loving and risk- averse investors, and the strategy of diversification.
4. Amanda, a financial analyst, wants to hedge against the low interest rates charged by banks on her sav- ings account. Advise Amanda.
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 inter- est-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 here 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.
You can obtain the current URL for the interest-rate forecasts on the Web site www.pearsonglobaleditions.com/
Mishkin. In addition to the displayed interest-rate fore- cast, you can see what the leading economists predict for GDP, inflation, unemployment, and housing.
FOLLOWING THE FINANCIAL NEWS
Forecasting Interest Rates
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5. Investors with risk-loving characteristics will pur- chase securities with higher expected returns, lesser risks, and more liquidity. Do you agree with this statement? Discuss.
For items 6–13, answer each question by drawing the appropriate supply-and-demand diagrams.
6. An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public. Using a supply-and-demand analysis for bonds, show what effect this action has on interest rates.
7. Using the supply-and-demand for bonds framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).
8. What will happen in the bond market if the govern- ment imposes a limit on the amount of daily trans- actions? Which characteristic of an asset would be affected?
9. How might a sudden increase in people’s expecta- tions of future real estate prices affect interest rates?
10. Suppose that many big corporations decide not to issue bonds, since it is now too costly to comply with new financial market regulations. Can you describe the expected effect on interest rates?
11. In the aftermath of the global financial crisis, U.S.
government budget deficits increased dramatically, yet interest rates on U.S. Treasury debt fell sharply and stayed low for many years. Does this make sense?
Why or why not?
12. How would the demand curve for corporate bonds be affected if news about accounting scandals in major corporations spread? What would be the effect on interest rates?
13. Will there be an effect on interest rates if brokerage commissions on stocks fall? Explain your answer.