Suppose that the Federal Reserve did not conduct any open market operations and allowed interest rates to freely float, while the treasury continued borrowing to fund the budget deficit. What would interest rate (on treasury bonds let's say to be specific) be? I am trying to understand how artificial current interest rates currently are.

  • 5
    There's no way to know the answer to this question definitively, because the market is not deciding the price. Further, it's not clear that this question is directly related to personal finance, because without political intervention, this will never change. – NL - Apologize to Monica Nov 5 '14 at 16:50
  • @NathanL I think it influences personal finance decisions as far a calculating the present value of a stream of payments (rental income, corporate profits, etc.). What discount rate should be used? Is it wrong to use artificially lowered interest rates in such a long term calculation? Is there a better value to use, and if so what? – DavePhD Nov 5 '14 at 17:04
  • Perhaps you should edit the question to better reflect the intent. – NL - Apologize to Monica Nov 5 '14 at 18:24
  • I agree with Nathan that this question is impossible to answer but you might get a better exploration on Quant.StackExchange.com – Matthew Nov 5 '14 at 19:03
  • If you do end up figuring out a good way to figure out what rates would be without central bank intervention, please let the world know. It would be very helpful for investors. I personally, however, am not convinced that it can be done, but I would love to hear otherwise. – DJG Nov 6 '14 at 19:07

While Nathan is correct above that government actors, not just the Fed but all actors including foreign, will likely never stop monitoring and manipulating the US interest rates. This doesn't mean that the market is not deciding the price! While the Fed is clearly has a lot of influence in this market they are but one participant and while they do change the yields the value does currently freely float. It is not set to a value by law.

This means your question can be answered as long as you are willing to take into account that the market always includes the possibility of future intervention by government actors domestic and foreign.

Long-term interest rates (10-30 years) include a lot of time where the current intervention will have likely stopped. Rates that far out are currently 2.4-3.0%. However, this is not quite the right answer either as the 10 year value, for instance, includes at least a year more of open market operations and some time effects for locking your money up for that long.

To correct for this you can calculate forward interest rates which are essentially the expected short term rates in the future beyond the period. This can give you a feel for what the market expects the interest rates to become after the current intervention. For instance, the 1 year rate today is around 0.11% while the one year rate a year from now is expected to be 0.40% or so.

Choose a time after you think the current interventions will be completed (three years?) and it is really easy to calculate.

  • Note that this is assuming no inflation. In the presence of inflation, interest rates increase as well. I can remember getting about 10x the bank interest rate I get now, during a period when inflation was taking most of that away as fast as it came in... – keshlam Nov 5 '14 at 22:45
  • I would disagree. The difference between the yields for inflation-linked bonds and standard bonds indicate that while the expected future inflation is not large it is certainly included in the above rates. Note that while this expected inflation is low compared to history, at least the part that most people remember, if most market participants expected something different it would be reflected in the above. – rhaskett Nov 6 '14 at 0:00
  • 1
    As I say: You're making an assumption. It may be the assumption "most people" are making, but it needs to be explicitly called out so folks can decide how much they trust it. – keshlam Nov 6 '14 at 0:32
  • ahh, well, in that case, can we agree that inflation is included in the above process and my assumption is merely that I don't think my opinion on future inflation is more valid than the sum of the market participants? – rhaskett Nov 6 '14 at 1:03
  • If I'm trying to project the future, I want some guess at error ranges around all the numbers. Your mileage will vary. – keshlam Nov 6 '14 at 1:34

Not the answer you're looking for? Browse other questions tagged or ask your own question.