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Update: Predicting CD Rates

There’s been some chatter about Tom Sargent’s 2007 commencement speech.  It wasn’t really a speech so much as it was an anti-government generalization, but I found this comment by Alex Tabarrok interesting:

After he won the Nobel, Tom Sargent was “interviewed” in an ad for Ally bank in which his response was simply (and correctly), “no.”

I’ve discussed this in the past, but I wanted to update it because I think Sargent is very wrong here.   You may remember those commercials for Ally Bank where Sargent is sitting in a room and someone asks him if he knows where CD rates will be in 24 months.  Sargent confidently says no.   I find this so strange.  This blanket dismissal is some weird combination of rational expectations, efficient markets and the myth that interest rates are a price controlled entirely by the market.  And like Sargent’s anti-government speech, it’s wrong in large part because his views are jaded by political myths.

17 months ago, I said:

“When one understands how the monetary system works (see here for a detailed description) you know that long bond rates are just a function of short rates which are a function of the Fed’s expectations for future economic conditions.  So fixed income traders are essentially trying to constantly front-run the Fed’s expectations.  There’s some variance in long rates due to the element of market control, but in an environment like the current one I wouldn’t say there’s much.  (See here for a more complete discussion on this).

The short end of the curve where CD rates are pegged is even easier to predict in this environment.  And it doesn’t take a seasoned fixed income trader to understand this.   Short rates like CD rates essentially ARE the overnight rate.

I think there’s a very very high probability that this is also a solid two year prediction.  Throw in the fact that Q4 GDP is likely to be under 1% and I’d be willing to bet that CD rates will be roughly the same as they are now when 2015 rolls around.”

As you all probably know, CD rates are still near 0%.  If, in 7 months, interest rates are still at 0% (which I presume they will be) then it’s obvious that the Sargent commercial was wrong that “no one” can predict where CD rates will have been.  In fact, just listening to the Fed’s own forecast made it an exceedingly high probability bet.  Of course, there’s some guesswork in all of this.  Predictions always involve some guesswork.  But it’s a lot easier to make good predictions about future macro conditions when you have a sound understanding of the monetary system as opposed to working from this mythological premise that drives so much of mainstream economic thinking these days.

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