PERHAPS, one of the most boring economic variables to forecast is the annual average interest rate. Why? Because there is no need for sophistication in the needed mathematics and no challenge of any sort in terms of economic modeling. Consider the 91-day Treasury bill (T-bill), the interest rate on which is the one that most, if not all, market-determined rates go with. What would be the best forecast for next year? Simply look at the newspaper and look at its current rate, and there you have it. The best forecast of the future interest rate is the present one.
In economics jargon, the time-series process of the interest rate is characteristic of a “random walk”. A metaphorical version of random walk goes along with the story of an ambidextrous adult whose feet are of the same length. If a man is right-handed (or left-handed), any time he puts his feet together and then makes a step forward, he will tend to use one foot more than the other. But, if he happens to be ambidextrous, he will use one foot as often as the other. Whether the man will use the left or right foot the next time has nothing to do with what he currently uses. Because the right foot is as long as the left, the distance leaning to the right is as long as that to the left. And because the man does not grow any taller, the distance on either direction is constant forever.
Consider the scatter diagram above, where the interest this year is plotted against next year’s. The data, taken from the Bangko Sentral ng Pilipinas website, cover the average annual interest on the 91-day T-bill from 1970 to 2010. The crisis years, when interest reached over 20 percent, are not included for “cosmetic purposes,” though the trend observation would still be basically the same. Any point below the line represents a scenario where interest this year (say, 2009) is greater than interest next year (say, 2010). Any point above is the opposite. Behaving like a random walk, interest next year increases over this year’s interest as much as it decreases under the line. Whether it will increase or decrease next year has nothing to do with what happens this year. It is as if interest is an ambidextrous adult. If any dot above the line is a positive distance and any point below the line is a negative one, the distances of the dots to the line average out to zero. It is similar to the person whose feet have the same length. The distances above the line are as far as those below it. It is as if the adult does not grow any taller in walking from zero to 16.
This implies that market players incorporate all past, present and probable future outcomes into the interest rate. The only thing that will change it are some news. Because news is random, the interest rate can be forecast to be random. If people are pessimistic and expect bad news to come more often, there is no reason for them to evaluate the interest rate optimistically. Rather, they will incorporate their pessimism into it, so that the interest rate adjusts to their pessimistic view of a situation, in which, once again, the weighted impact of pessimism equals that of optimism.
As of the latest data, the 91-day T-bill has an interest rate of 1.14 percent. The only thing that will change this will be good or bad news. If people think optimistically and expect a credit upgrade or a stable evaluation from credit-rating agencies, there is no reason for them to evaluate that there would be a credit downgrade or an unstable evaluation, as if the interest rate would increase to, say, 2 percent. Rather, they have incorporated their optimism into it, so that the interest rate is the current 1.14 percent. Going further, anything that can be anticipated, from politics and the weather to anything in the universe, has already been incorporated to make it 1.14 percent. The only things left unanticipated are sudden news events. The process of forecasting begins at 1.14 percent. With positive news and negative news balancing, it becomes like tossing a coin: It may be less or more next year. But, still, the best forecast is the average that is represented by the current interest rate.