Monday, March 21, 2011

Looking for Reliable Interest Rate Predictions

A colleague recently asked me if I knew of a good source for reliable interest rate predictions. He was trying to decide whether to break his mortgage and pay the interest rate differential. He only wanted to do this if interest rates were headed back up and it made sense to lock in today’s low rates.

As is often the case, I knew the correct but unhelpful answer. Nobody knows for certain what will happen to interest rates. Even the U.S. Federal Reserve and the Bank of Canada can’t say what will happen to interest rates with any useful accuracy. These organizations react to world events more than they control them.

The yield curve gives the collective interest rate predictions of the financial markets, but rates could be higher or lower than predicted levels. We need to stop looking for financial prophets and make financial choices assuming a range of possible outcomes.

The curious thing about this line of reasoning is that I’ve had people agree with it and then proceed to explain what they think would happen with interest rates. Humans seem to be wired to make predictions even when we have no idea what will happen.


  1. It seems to me the bank's best prediction of future interest rates would be reflected by the difference between fixed and variable mortgage rates they're offering. In a rational market, this differential must be composed of (1) the difference between the current rates and future rates, plus (2) a premium to reflect the shifting of risk to the bank.

    If someone were to ask me that question, I'd tell them they'll never find a source of interest rate predictions that's superior to the one the bank already used when they set their rates.

  2. @Patrick: Of course, these bank rates are driven by the financial markets. But the banks are good at interpreting the market signals for their own purposes and are a good place for the average person to look for interest rate predictions. It's important to remember that there "predictions" are really just a level based on a balance of probabilities. A range of rates are possible and the "prediction" is just somewhere near the middle.

  3. I think you're right that we need to stop looking for financial prophets. We need to make our decisions based on the facts that we have and the potential risks we can see. I disagree that we need to plan based on a range of outcomes, only because it would be sufficient to plan based on a worst case scenario. Then, if things work out better, the outcome could only be better than expected, not worse.

    An excellent post.

  4. @Robert: Thanks for the kind words. I think I know what you mean by planning for the worst case scenario, but if taken literally, I see two problems. The first is deciding on a threshold probability for bad events. There is no sense worrying about money at all if the worst case scenario is that you'll be hit in the head by a meteor soon. The second is that ignoring upside can lead to overly conservative choices. I think it is reasonable to buy a house if you could only afford interest rates up to 20% over the next 5 years, even though it is possible for rates to go above 20%. The upside of the high probability outcome of happily living in your own home for a reasonable mortgage payment compensates for the small probability of ruin.