The Fundamental Determinants of the Interest Rates

Abstract

This paper assesses the fundamental determinants of changes in the long-term interest rate. Most recent studies of bond rates have emphasized the term structure relations between the bond rate and short-term interest rates.1 Although we recognize that the individual investor is very much influenced by arbitrage opportunities between different maturities, we wish to look behind the intercorrelated structure of interest rates to the economic forces that shift the entire level of interest rates. The result of our analysis is a synthesis of Keynes' theory of liquidity preference and Fisher's model of the role of anticipated inflation. Our estimates also show the importance of the public debt and of investors' expectations of future changes in the interest rate. We begin our study (section I) by considering a very simple, but nevertheless effective, liquidity preference theory. This is then generalized in a variety of ways by subsequent sections. Section II introduces the important effects of expected inflation, emphasized by Irving Fisher as early as 1896, but generally ignored by economists in more recent years. In section III, the liquidity preference theory is extended to a more general portfolio balance model by introducing privately held government debt. Section IV explicitly considers the implications of expected interest rate changes. Finally, section V examines flow disturbances that may cause the interest rate to depart from the equilibrium level. In sections I through V, the analysis deals with the average yield to maturity on Moody's Aaa corporate bonds, i.e., high grade bonds that are already several years old and have approximately 25 years to maturity. The yield to maturity includes a capital gain (or loss) if the current market price of the bond is less than (or greater than) the redemption value. No allowance is made for the special tax status of capital gains and the resulting distortion in yields during periods of substantial changes in coupon rates. To remedy this, section VI applies the generalized liquidity preference inflation model of section V to the yield on newly issued Moody's Aaa bonds instead of the yield on seasoned bonds. Section VII uses the generalized liquidity preference inflation equation to decompose the change in interest rates since 1954 into the separate effects of the several variables. A concluding section summarizes the results. The estimates generally relate to the 62 quarters from 1954:1 through 1969:2. The use of this period avoids the special characteristics imposed on the bond market by government behavior before the Treasury accord and unpegging of interest rates in 1951. Further details about the definitions of the variables used and the methods of estimation are discussed in the sections that follow.