What Are Interest Rates?

Interest rates are the penalty you pay for purchasing something today instead of postponing consumption until tomorrow. They are also the reward you receive for saving and engaging in delayed gratification.

I don’t mean to get all philosophical in The 10th Man, but one thing I’ve noticed about interest rates is that people have all kinds of theories as to what makes them go up or down. The theories are more or less meaningless. Rates went down for 35 years. Did they go down for 35 years because economic growth slowed? Did they go down for 35 years because inflation moderated? Did they go down for 35 years because money velocity slowed? Productivity? Energy prices? Risk premia? Does any of this stuff matter?

I find that theories such as these (like a lot of things in finance) are explanatory rather than predictive. Ex-post, you can look back and say, “Okay, interest rates went up because of inflation or this or that,” but these sorts of things don’t really help people predict the direction of interest rates. In my experience, not a lot of people have had success in forecasting interest rates. Interest rates have made fools out of all forecasters. Unless you look at the flows.

For me, a flow model for forecasting interest rates is much more helpful because, at the end of the day, interest rates are a function of the supply and demand for government bonds. If China sells $50 billion of government bonds, interest rates will go up. If the Fed buys $50 billion of government bonds, interest rates will go down.

Currently, interest rates are going up, and some people are using the flow model to explain the price action. We have a lot of Treasury issuance because we are running giant deficits. China is selling. Still, people have a very static view of the flows, as if these conditions will exist from now until the future.