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| The Basics | A borrower's guide to forecasting interest rates
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It's hard to predict when these forces will come into play, but most economists agree that these key factors play major roles in determining interest rates.
By Tom Woodruff
This article can help save you a lot of money. Its Economics 101. But instead of a professor boring you to death, were going to explain why it really matters to you. If you understand a few basic tenets of what makes this nations economy tick, you can save thousands of dollars on everything from your mortgage to your credit cards.
For example, on a $200,000 mortgage, the difference in monthly payments between a 30-year mortgage at 7% and at 8% is $137 a month. Over the life of the loan, thats $49,293 you can save on one measly percentage point. Now that weve got your attention, lets figure out how this works.
The big picture
Economists, particularly a breed known as macro-economists, spend a lot of time thinking about what influences interest rates. While economists are about as bad at forecasting future interest rates as your local weatherman is at forecasting next weeks weather, most economists agree there are several fundamental forces that determine how interest rates get set in the economy. And even though it might be hard to predict when these forces will come into play, its important to know what they are:
- The amount of money saved in the economy, mostly households. That means you.
- Business demand for these funds to be used to finance new plant construction, equipment, and inventories or supplies.
- The governments net supply of funds or demand for funds.
Now heres another issue: These forces determine what is called the real interest rate, which is the interest rate minus the rate of inflation in the economy. Historically, the real interest rate in the United States has hovered around the 3% mark. But that information isnt enough when youre trying to understand what interest youll pay on loans or receive from interest-bearing accounts. You also need to know what factors contribute to the rate of inflation in the economy and what reports economists use to determine whether inflation is on the rise.
Leading inflation indicators
The key reports that can indicate if inflation is kicking in are: the Department of Labor employment report, the quarterly worker productivity report, the employment cost index (ECI), and the gross domestic product (GDP). The key reports for measuring inflation are the consumer price index (CPI) and the producer price index (PPI).
Department of Labor employment reports: This is one of the anomalies of economics. In this theory, low unemployment often leads to higher inflation. Thats why the stock market often declines when the latest unemployment rate comes out, showing that more people are on the job. Its a good news/bad news scenario.
Thats why so many economists take note on the first Friday of each month when the Labor Department announces the employment figures for the previous month. This report estimates the number of workers added to the non-farm payroll. (The government counts farm workers separately because the work is so seasonal and fluctuates wildly.) This report is seen as a harbinger of inflation and, thus, higher interest rates if it shows tightening labor markets that could lead to increased pressure for higher wages. This is particularly true when the overall rate of unemployment is low.
Employment cost and productivity: One way to stem the bad news that unemployment is low is if we as workers succeed in making more things faster. Increases or decreases in worker productivity can offset the impact of tight labor markets reported in the employment reports.
For example, increases in productivity can offset inflationary pressures due to tight labor markets and increased wages. In addition, the Labor Department issues a quarterly employment cost index that shows if employers have increased wages to keep their workers. Its another good news/bad news scenario. If employers have to pay more money, the expectation is that inflation cant be far behind. Higher wages equal a higher inflation rate.
Consumer price index: The consumer price index is the most commonly cited measurement of inflation. The CPI is the price of a basket of goods and services that consumers purchase. While the CPI has come under considerable criticism lately for not accurately reporting inflation at the consumer level, it remains the best measure that we have. Recently, for example, a study led by Michael Boskin, former chairman of the Council of Economic Advisors, found that the CPI overstated actual price inflation for consumers. Starting in 1998, partially in response to the Boskin report, the weighting of the CPI market basket has changed to reflect some of the Boskin reports findings.
Producer price index and the gross domestic product: The gross domestic product, the total of what's produced in the economy, and the producer price index, the price of goods and services at the wholesale level, are also widely reported.
The PPI generally is a predictor of what will happen at the consumer level in the future. So it gives you a look ahead at what to expect in terms of interest rates.
The GDP is a harder indicator to read because it measures how much our domestic economy is producing. Generally, though, economists worry that if the economy grows too fast, price inflation will increase, and so will the interest rates that we earn and pay.
You can influence your loan rate, too
While general economic trends determine the overall interest rates in the economy, lenders are increasingly using what they call risk-based pricing in consumer lending, ranging from credit cards to car loans to even your home mortgage.
The basic idea of risk-based pricing is that instead of a lender offering a one-rate-fits-all loan based on current market conditions, the rate is also based on your credit and risk history. The core of the customized risk profile is called a credit bureau score. It gives a numerical score to a number of factors, such as your age, income, marital status, number of years in your home and at your job and of course, your credit history.
The most widely used credit bureau score, the FICO credit score, is based on a statistical model developed by San Rafael, Calif.-based Fair, Isaac & Co. According to Fair, Isaac, its model was developed by taking raw credit bureau data on millions of borrowers and creating statistical routines that would help predict the probability of a borrower defaulting on a loan.
The bottom line
Just looking at interest rate trends is only half of the equation in determining the amount that you will pay on a loan. When you go to your bank to apply for a loan, youll have to wait until the bank receives your credit bureau score before youll know what interest rate it will offer you. If you have a squeaky clean credit bureau report, you are likely to receive the best loan rates available in the economy. If you receive a low score, you wont.
Understanding the economy, and how your own personal economic situation can affect the rates you pay on everything from mortgages to credit cards, can save you a lot of money in the long run.
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