Abstract

This paper forecasts the future of interest rates in the U.S. economy for the next two years. By examining the Loanable Funds Model and the past ten years interest rate movement, this paper will show the future of interest rates for the United States. The explanatory variables used are the U.S. money supply and interest rates. 3-month Treasury Bill Interest Rates are forecast to increase approximately 78 basis points until September 2001. The forecasting results were that interest rates should remain very stable and should have nearly zero fluctuation for the next two years. (JEL: E51, E52)

Part 1. Introduction

This paper forecasts 3-month Treasury Bill Rates in the Secondary Market through 2002.01. The explanatory variables used in this forecast are the 3-month Treasury Bill Rates in the secondary market and M2 money supply. This forecast is based on the Loanable Funds Model, which explains the relationship between the money supply and interest rates.

Interest rates are the cornerstone of the United States economy. Interest rates are important because consumption and investment are directly influenced by there fluctuation. Due to the short time span of this forecast and a stable Federal Reserve policy, this forecast should be relatively accurate.

The rest of this paper is organized as follows: part 2. presents the data used to forecast interest rates; part 3. presents the theoretical basis for the approach in forecasting interest rates; part 4. present forecasts of interest rates through 2002.1; part 5. evaluates the importance of the forecast to the economy; and part 6. discusses conclusions for the economic policy.

Part 2. Data

All variables are taken from the Federal Reserve Bank of St. Louis Federal Reserve Economic Data (FRED). The M2 money supply for FRED is variable M2SL. The data is seasonally adjusted, measured in billions of dollars, and reported monthly. The 3-month Treasury Bill Interest Rate is FRED variable TB3MS taken from the secondary market and given as a percent discount. The 3-month Treasury Bill Rate is also given monthly. The sample period for the data used is from January 1990 through January 2000. To illustrate this, a regression of Money supply was completed.

Loanable Funds Model, which revolves around the money supply, portrays interest rate movement. The Federal Reserve controls interest rates by increasing or decreasing the supply of money in circulation. This forecast of interest rates is explained by the Loanable Funds Market, which brings together savers, the suppliers of loanable funds, and borrowers, the demanders of loanable funds. This determines the market rate of interest. Therefore, the supply of loanable funds is a direct reflection of the market rate of interest and the quantity of savings, with other variables remaining constant. The banks play the role of a financial intermediary between the Federal Reserve and consumers. The greater the interest rate, the more consumers are rewarded for saving. The lower the interest rates, the more consumers are willing to spend.

An alternative approach to this forecast would be to use the Monetarist policy. However, this forecast uses the Loanable Funds Model and previous information on interest rates found in FRED. This approach is much simpler.

Part 3. Economic Theory

Monthly interest rates will be determined two years into the future using the M2 Money Supply from FRED. The values for interest rates are determined using the Loanable Funds Model and the following equation:

r_t= f (r_t-2, M2_t-2)

This a simple model appropriate for forecasting interest rates based on the Loanable Funds Model. The forecast should be interpreted as current interest rates being a function of interest rates lagged by two years and M2 money supply also lagged by two years.

Part 4. Forecasts of Interest Rates

The equation was forecast by an ordinary least squared regression for the periods 1990.01-2000.01. The Adjusted R-squared estimated is 0.406659, which indicates approximately 40% of the variation of r is explained by variation in M2. The intercept of the forecast occurred at 0.697305, with an estimate of .562571 = 56%. The estimate of the equation is (t-statistics in parentheses):

r_t= .697305(.58109) + -0.30012(-5.82212)r_t-2 + 0.001482(4.65023)M2_t-2

The Interest rate function was estimated using M2 money supply data from January 1990 and January 2000. The following is an example of this calculation using the following formula:

r_2000.02= 0.697305-0.30012*5.09 + 0.001482*4098.74 = 5.24

This forecast estimates the 3-month Treasury Bill Rates in the Secondary Market through 2002.01 using the M2 money supply.

This forecast was done for two years into the future using the above formula and is presented in Table 1.

Table 1 Forecast 3-month Treasury Bill Rates – Secondary Market
*Quarter*	*Forecast*
2000.2	5.24
2000.3	5.31
2000.4	5.37
2000.5	5.38
2000.6	5.43
2000.7	5.46
2000.8	5.51
2000.9	5.67
2000.10	5.92
2000.11	5.84
2000.12	5.90
2001.1	5.95
2001.2	5.96
2001.3	5.98
2001.4	6.06
2001.5	6.04
2001.6	6.04
2001.7	6.08
2001.8	6.06
2001.9	6.10
2001.10	6.07
2001.11	6.04
2001.12	6.04
2002.1	6.04

This forecast is favorable because interest rates rise 78 basis points over a year and a half and then begins to decrease the remaining six months.

Part 5. Calm Waters Ahead

This forecast is favorable for all people considering the consistency that it predicts. Interest rates were predicted to stay the same for the next two years. This is not a crazy idea with stable inflation and sound economic leadership in the Federal Reserve. If interest rates stay relatively low, the economy should experience continual growth. With inflation held in check, the future of the economy is very bright. This paper recommends all U.S. consumers to not shy away from the market or a mortgage loan.

Part 6. Policy Conclusions

Interest rates should stay the same at a steady 6.04 percent. This is due to stable government and monetary policy. The country is in a golden age right now of technology and business. We are also experiencing very low inflation. This coupled with other successful economic factors; it appears that the future is stable and flourishing.

1). This forecast suggests that industry spend money on lots of research and development. With the economy and technology growing so fast it will be important to stay ahead. The only way to do that is to invest in the future growth.

2). The Federal Reserve has done a great job recently with monetary policy. This forecast recommends that it stays relatively conservative with loanable funds. The saying “don’t mess up a good thing” would be good for the Federal Reserve to meditate on. Stable policy should help allow our economy to have proper checks and balances on itself.

References

Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED), http://www.stls.frb.org/fred/ (20 February 2000).

McEachern, William A. “Economics: A Contemporary Introduction.” Cincinnati OH: Southwestern Publishing Co., 1994.