The basic theory of interest rates can be broken down into two basic concepts. The first concept is what is called the forward rate. The forward rate describes the future rate at which banks will charge interest on loans. This interest rate, when expressed as a percentage, is known as the forward interest rate. The next basic concept is the present interest rate.
The present interest rate is what is charged today on loans to investors or borrowers. The forward interest rate, or the future interest rate, is a projection of the future rate at which the future rate will be determined after a period of time. The forward interest rate is the most flexible of the two concepts.
For example, a bank may anticipate that interest will be higher than normal in three short time periods. The present interest rate will be higher than the normal interest rate. But if it is higher than the normal rate for three months, the forward rate will be much lower than the normal rate. So, when the forward rate becomes normal, the bank will charge more interest for the loans. This is the forward interest rate.
The reason that this interest rates can change rapidly, and often wildly, is because banks do not have a fixed rate for loans. They use a variety of factors to determine what the future interest rate will be. But, by predicting what future rates will be, they are able to control the rate at which the future rates are determined. This means that by forecasting the future rate, banks can lock in the interest rate at a certain level and not let it go up or down.
It is possible for the banks to predict, ahead of time, what the future interest rate will be, even before the rates go up. Once the prediction is made, banks have the ability to control the rate at which the rates are determined. in such a way that the interest rates are more predictable than they would be if they were not predicted.
Banks know that the future interest rate is important because they can use it to attract people to come into their doors. When the future interest rate is low, there is less competition and thus a lower risk to the bank. In fact, by controlling the rate, the bank has greater control over the value of its assets than it would by keeping the rate lower. In a recession, a lower risk rate can mean a higher return.
Even the future rate of interest is dependent upon the economy. In a recession, the economy may be expected to slow down. However, if the unemployment rate is expected to stay the same, the interest rate will remain steady. But if unemployment is expected to rise, the interest rate may move up. Thus, the stability of the interest rate depends upon the state of the economy.
Expectation theory also has a lot to do with inflation. If inflation is expected to rise, the interest rate may rise.
As a result of this principle, interest rates can be determined based on a forecast of the future of the interest rate in the future. That future interest rate can then be used as leverage to make better interest rates predictions than could be made if the prediction was not based on an assumption about how future interest rates will behave.
Of course, the predictions that we make about future rates are subject to human error. So we cannot simply rely upon these predictions to make better interest rates predictions.
Future interest rates can affect our future lives in a variety of ways. We can use the predictions to help us to determine whether we should take out loans now.