Why We Can’t Predict Interest Rates

An article in the Financial Post has impugned me honour and the honour of other fine economists (thanks Capt. Barbossa for the verbiage).The basis of the negative press has to do with the inability to accurately predict future interest rates. I thought, therefore, that I would take this opportunity to defend my colleagues and explain why forecasting some economic variables is so difficult. In particular, I want to look at interest rates.

First, let’s be clear that there are several different interest rates. The money market rate is the rate charged on overnight loans between financial institutions. This is the rate that the Bank of Canada uses as its policy instrument. As of Jan 2, 2014, this rate was 1%. The Bank uses this interest rate to influence economic activity and the inflation rate.

The bank rate is the interest rate the central bank charges for overnight loans to major financial institutions. The bank rate is always 25 basis points above the target overnight rate. (1 basis point = 1/100^th of 1%) When the target rate is 1%, the bank rate is 1.25%.

The prime rate is the interest rate that banks charge their best customers for short term loans. Since our banks can borrow as much money as they want from the Bank of Canada, the prime rate is closely linked to the bank rate.

The long term bond rate is the rate received for lending to government and corporations. Bond rates differ due to credit worthiness and by the length of the loan (maturity). Generally, the longer the maturity, the higher the interest rate will be. It is this interest rate that influences private business investment and the residential mortgage market.

Long term interest rates are determined by the demand and supply of loanable funds, or equivalently, the demand and supply of bonds. Central banks don’t have direct control on these rates but they can influence through open market sales and purchases of bonds with different maturities. This is what the US Fed is doing with its quantitative easing program.

To accurately predict short term interest rates we look to the Bank of Canada’s objectives and their policy tools. The Bank’s objective is to keep the inflation rate, as measured by the change in the core CPI, at 2% per year. They have an ‘operational guide’ of 2% plus or minus 1%. That is, they want to keep the inflation rate between 1% and 3% per year.

When economic activity; consumer spending, construction, exports etc. decreases, unemployment tends to rise and the inflation rate tends to fall. In response to this, the Bank lowers the target rate to encourage investment spending. When the economy expands too rapidly, the inflation rate rises, and the Bank raises the target rate to down the rate of expansion.

When will inflation rates rise? Not an easy question to answer. In the last several years the potential output of the economy has been growing faster than actual spending. Inflation increases when the economy gets close to capacity. A core inflation rate of 1.1% indicates that the Canadian economy is not operating at close to capacity. The US Bureau of Labor Statistics reports US inflation at 1.7% indicating that our biggest trading partner is also operating below capacity. Inflation.eu reports inflation rates of 2.09% in Great Britain, 1.34% in Germany, 0.68% in France, 0.23% in Spain and 0.66% in Italy. With little inflationary pressure in any of our other major trading partners, interest rates are not likely to increase there either.

So, when will interest rates rise? Not anytime soon!