What Really Drives Long-Term Interest Rates?

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Yves here. It’s gratifying to see Philip Pilkington, who wrote some fine pieces for this humble blog before landing at a major investment firm, back to writing articles for the general public. Here, with co-author Brett Palatiello, Pilkington takes on the old canard of the loanable funds theory and demonstrates that it’s irrelevant to setting of long-term interest rates. For those not familiar with it, the “loanable funds” theory stipulates that there is a pool of savings from which loans and investments are made. Long-term interest rates supposedly represent the clearing price for the demand v. the supply for funds. The loanable funds theory plays a major role in mainstream macroeconomic models.

In reality, there is no fixed pool of savings that limits the supply of loans. Banks create new loans out of thin air.

By Brett Palatiello, Head of Systematic Macro & Equities, Ridgewood Analytica, and Philip Pilkington. Originally published at the Institute for New Economic Thinking website

Most of the empirical literature on long-term interest rate determination – at least, the neoclassical literature – is based on the old loanable funds theory. That theory states that interest rates are determined by the supply of and demand for loanable funds. Since the pool of loanable funds is fixed, an exogenous increase in demand – say, from a government spending program backed by bond issuance – will lead to higher interest rates.

The alternative theory is the Keynesian one. Keynes held to an expectations-based theory of interest rate determination. He believed that long-term interest rates represented market-expected short-term interest rates projected into the future – a “highly psychological phenomenon,” as Keynes wrote. How do markets come to estimates of future short-term interest rates? Keynes argued that they arrived at them through ‘convention.’ By ‘convention’ he meant just that – whatever markets think that markets should think.

Just what sets this convention has changed through time. In Britain, after the country returned to the gold standard in 1821, the market for Consols – that is, perpetual bonds – settled into a long period of calm. Even though inflation was highly volatile in this period and even though the Bank of England did not intervene in the Consuls market with a view toward stabilizing rates, the yield on Consols never exceeded 4% or fell below 3%. The table below compares British Consol yields in this period and British inflation with 30-year United States Treasury yields and inflation since 1977.

Standard Deviation Inflation Beta (Bonds:Inflation) Max Min
Consul Yields 1822-1880 0.18 -0.01 0.03 3.81 3.03
10 Year MA 0.10 -0.03 0.09 3.54 3.18
British CPI 1822-1880 5.24 15.66 -14.40
10 Year MA 1.07 2.64 -1.98
US 30y Treasury Yield 1977-2021 3.01 0.74 0.43 13.45 1.56
10 Year MA 2.53 1.61 0.83 10.83 2.71
US CPI 1977-2021 2.68 13.50 -0.32
10 Year MA 1.43 7.38 1.46

Source: Bank of England, BLS, Board of Governors.

It quickly becomes apparent that there are different “conventions” at work in these two markets.

Keynes held that in our modern-day economies central banks have full control over short-term interest rates and that markets build their expectations of future interest rates by closely watching what the central bank is saying and doing. In today’s markets, this is called “Fed-watching.” Lacking the assured calm of Victorian Britain where the yield on a perpetual bond was between 3% and 4% simply because that is the way the world is, modern investors turn to their central banks to set market conventions. We have moved from convention-by-popular-agreement to convention-by-central-bank-fiat.

Now that we understand the two competing theories, we can test them by using the government’s fiscal stance as our experimental variable. If the loanable funds theory is true, then we should expect to find a strong relationship between government deficits and long-term interest rates. If the government is issuing bonds into these markets for their spending programs and these bonds are “soaking up” cash, then interest rates should rise almost mechanically. Expectations, in this model, would only create some short-term noise; in the medium-to-long term, the relationship should be ironclad. If, on the other hand, the Keynesian view is true, then we would expect to find a skittish, unstable relationship between government deficits and long-term interest rates. This is because the government deficit will be only one amongst many variables that Fed-watchers will consider when trying to guess at future moves by the central bank.

We use a standard Taylor Rule framework to examine this relationship, but we add an expectations variable, a term premium variable, and a risk aversion variable. The expectations variable allows the central bank to induce changes in the long-term rate through its impact on perceived future short-term rates. This variable is determined by signaling, open market operations, and the capacity to set the short-term rate explicitly by fiat. We are not deploying a Taylor Rule framework to determine a “natural” rate of interest, as is typically done. Rather we use it as a simple central bank reaction function that we believe gives a fair representation of what Fed-watchers are thinking when they watch the central bank.

For our empirical work, we take a variety of measures of the long-term interest rate and of the deficit. For interest rates, we use the current 10-year Treasury rate and the 10-year Treasury rate 5 years forward. For deficits, we use: CBO projections of 5-year future deficits-to-GDP; the total current deficit-to-GDP; and the structural deficit-to-GDP. We then add our central bank reaction functions by including inflation expectations from the Survey of Professional Forecasters for inflation expectations; the Federal Reserve Board model of the output gap; we also include the level of Federal Reserve holdings of government debt as a percentage of GDP; and to proxy for risk aversion, we use the VIX index, the binary NBER recession indicator. and flight-to-safety episodes from Baele et al.

The results are laid out in the table below. Projected deficits have an insignificantly negative long-run impact on the forward rate though in the short run there are both significantly negative and positive impacts at lags zero and one, respectively. For deficits excluding automatic stabilizers, there is a significantly positive effect in the short run at lags one and three of about 15 and 16 basis points respectively. However, there is a significantly negative effect in the long run of -27 basis points which takes less than three quarters to accumulate. Finally, the total deficit only has an insignificantly negative coefficient of 12 basis points in the long run which also takes less than three months to accumulate with no corresponding impact in the short run.


Table 3: Estimated ARDL model for the long-term forward rate
Long Run b t-stat     b t-stat     b t-stat
INF 1.445 14.269   INF 1.377 15.001   INF 1.356 12.803
HOLD -0.273 -6.656   HOLD -0.280 -10.786   HOLD -0.286 -8.257
FOMC 2.689 3.981   FOMC 1.452 1.927   FOMC 2.673 3.984
GAP 0.384 1.330   GAP 0.012 0.040   GAP 0.007 0.017
VIX 0.006 0.285   VIX -0.009 -0.611   VIX 0.010 0.559
CBO5DEF -0.100 -1.142   GOVGDPAS -0.271 -3.471   TOTDEF -0.119 -1.631
C 4.127 7.009   C 5.273 8.929   C 4.761 7.195
Short Run b t-stat     b t-stat     b t-stat
Δ5Y10Y(-1) 0.038 0.594   Δ5Y10Y(-1) 0.076 1.194   Δ5Y10Y(-1) 0.025 0.399
Δ5Y10Y(-2) 0.051 0.783   Δ5Y10Y(-2) 0.064 1.013   Δ5Y10Y(-2) 0.054 0.828
Δ5Y10Y(-3) 0.173 2.663   Δ5Y10Y(-3) 0.214 3.430   Δ5Y10Y(-3) 0.158 2.459
ΔHOLD 0.002 0.027   ΔHOLD 0.194 1.992   ΔHOLD -0.021 -0.257
ΔHOLD(-1) 0.195 2.223   ΔFOMC 0.871 8.066   ΔHOLD(-1) 0.151 1.519
ΔGAP 0.309 2.409   ΔGAP 0.229 1.455   ΔHOLD(-2) 0.188 2.025
ΔGAP(-1) 0.359 2.890   ΔGAP(-1) 0.205 1.278   ΔGAP 0.087 0.620
ΔGAP(-2) 0.270 2.172   ΔGAP(-2) 0.461 3.090   ΔGAP(-1) 0.224 1.547
ΔVIX -0.011 -2.099   ΔGOVGDPAS 0.001 0.021   ΔGAP(-2) 0.388 2.815
ΔCBO5DEF -0.148 -2.399   ΔGOVGDPAS(-1) 0.146 2.181   ΔVIX -0.010 -2.005
ΔCBO5DEF(-1) 0.147 2.450   ΔGOVGDPAS(-2) -0.025 -0.382   USREC 0.172 1.447
USREC 0.218 1.714   ΔGOVGDPAS(-3) 0.158 2.359   FTS -0.245 -2.659
FTS -0.235 -2.544   USREC 0.059 0.500   ECT(-1) -0.370 -9.909
ECT(-1) -0.343 -9.836   FTS -0.205 -2.303        
        ECT(-1) -0.396 -8.147        
Lags (4, 0, 2, 0, 3, 1, 2)   Lags (4, 0, 1, 1, 3, 0, 4)  Lags (4, 0, 3, 0, 3, 1, 0)
LM(2) 0.614     LM(2) 0.401     LM(2) 0.680  
LM(4) 0.406     LM(4) 0.254     LM(4) 0.457  
RESET 0.343     RESET 0.982     RESET 0.452  
Notes: ΔX(-i) is the i lag of the first differenced variable X.

How would we summarise these findings? We would say that they are highly variable. There is no reliable impact of the deficit on long-term interest rates. When we do see some impact, it tends to be ephemeral and fades out quickly. This is what we would expect to see if the Keynesian theory of interest rate determination is true. When the deficit blows out and occupies the financial markets headlines, Fed-watchers sometimes react negatively and sell bonds. Presumably this is because they assume that higher government deficits lead to higher future inflation. This proves to be an extremely myopic view of inflationary dynamics as evidenced by the generally weak relationship between government finances and inflation. As the news cycle changes and an outsized deficit fades from view, interest rates revert to the path set for them through central bank guidance.

This variability also explains why other literature on this topic is, as we note in our literature review, so muddled. In the existing literature on deficits and interest rates, different authors find different things – with one establishing a relationship and another rejecting it. Both our findings and the existing literature taken in toto, lend support to the Keynesian theory of interest rates, a theory that emphasizes the role of uncertainty and convention in financial market price determination. We think this quote from GLS Shackle, summing up Keynes’ view, captures the evidence nicely:

Conventional judgments are those which, by some more or less accidental coalescence of ideas or some natural but hidden means of communication, are adopted by a mass of people who cannot find, and are not really concerned to find, any ‘solid,’ ‘objective,’ and genuinely meaningful basis of judgment… The character of judgments, opinions, and valuations thus arrived at will be a capricious instability. (Shackle 1972, p225)

Markets seek to avoid enormous amounts of uncertainty by anchoring themselves to some larger conventional norm. In 19th century Britain, strong normative social conventions anchored long-term interest rates. In our modern economies, we have opted for a technocratic or pseudo-technocratic solution: we have created central banks and an entire financial press that supports long-term interest rate determination by Fed-watching. This gives the market firm rock to stand on in a desert of otherwise shifting sands and can be captured empirically by a modified Taylor Rule. If the central bank announced tomorrow that it would decide on future short-term interest rate determination by looking at government deficits, then we believe the long-term interest rate would be set in this manner and a solid relationship would turn up in empirical estimates. But until that day, the government deficit is just another variable that pops in and out of existence in the financial news and leads, at best, to some short-term noise in the government bond markets.

In contrast to the loanable funds theory of interest rate determination, Keynes’ theory is a truly financial theory of the interest rates. Both present authors have spent most of their adult lives working in financial markets. Neither of us have ever seen a loanable funds model used to structure a bond portfolio. Both of us have seen Fed-watching on an almost daily basis, however. Keynes too spent a great deal of his life studying and playing the financial markets. We are not surprised by his theory. It is exactly the sort of theory a practical, experienced financier would come up with. Now the ball is in the economists’ court: will they take practical finance seriously and integrate it into their economic theories as Keynes did, or will they continue to insist that supply and demand diagrams are a solution to every economic problem?


Baele, L., Bekaert, G., Inghelbrecht, K., & Wei, M. (2020). Flights to Safety. The Review of Financial Studies, 33(2), 689–746.

Shackle, G.L.S. (1972). Epistemics and Economics: A Critique of Economic Doctrines. Cambridge University Press.

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  1. Objective Ace

    I feel like doing this analysis on interest rates rather then real interest rates misses something. I would think the gold standard is more of the reason for such consistent interest rates than “strong normative social conventions”. The gold standard ensures the currency issuer wont devalue the currency and leave you with significantly negative real interest rates. We do not have that guarantee now–just “Fed Speak” as the author mentions

    1. Mikel

      The global population exploded at the turn of the twentieth century. That’s alot of transactions that need to be covered by a currency. The gold standards days were numbered.

      1. Objective Ace

        I’m not at all saying one is better than the other. I’m just pointing out a result of using a commodity based currency–it’s easier to project how large the monetary reserve will be in the future

      2. rhodium

        Which is why you would have just gotten deflation. Terrible for anyone in debt, but completely mathematically workable.

    2. tegnost

      Fiat increases the vigorish by making the cost of money zero? You don’t need any gold to back it up, no storage costs, instead rehypothecation (which I guess one does with gold in an ETF, also?) and long bond expectations management, as described in the above, by the bookies, banksters, MoU, or whatever else they are called.

        1. eg

          The Financial Post is a Canadian publication of the purest neoliberal distillate. It is a revolting repository of hoary, misguided economic shibboleths.

          The only Canadian entity more responsible for disseminating monetarist orthodoxies in this country is the Fraser Institute.

          A pox on both their houses …

    3. eg

      “The” gold standard? Which one? Because in all of them the sovereign dictated the tems of convertibility.

  2. digi_owl

    Loanable funds is a good indicator that economics, at least in the mainstream sense, is stuck thinking in terms of coins and notes. Or commodity money if you like.

    Meaning that the lender would have to go into the vault, count up the amount agreed upon, and physically hand that to the borrower in exchange for the signature saying the borrower will pay it back with interest (or else).

    And from there you get all the other jazz, like the whole money multiplier bruhaha.

    but all that flies out the window the moment you introduce ledgers and checking accounts. Because now the only true limiter on the amount they can lend out is their ability to find borrowers. Meaning that now private banks can basically print money, and do so every time they approve a new loan.

    And from that you get all kinds of “fun” side effects. Like how Steve Keen observed that a change in the rate of change of debt resulted in changes all across the rest of the economy. Like say if each year the money in circulation grow by 2% from people buying on credit. Then one year that drops to 1%. Now all of a sudden there is half as much new money being injected into the economy. So retailers tighten belts. Then their suppliers tighten belts. Then their workers tighten belts. Oops, it seems we have a recession on our hands!

  3. fresno dan

    Money is loaned into existence. Took me a loooong time to figure that out. In the movie, Papillon at the end of the movie, Dustin Hoffman is left almost alone on an island, to spend time as he chooses. He is the decider about how much effort (building a wall to contain pigs, planting a garden) to expend to get how much benefit for hisself. Besides eating, he may enjoy gardening – he doesn’t have anything else to do…The more he lends himself “work” in the present, the more food, comfort he gets in the future. Of course, Dustin couldn’t create money to buy stocks on margin…
    So why was there a housing crash back around 2008? Mostly fraud, mostly by the people making the loans (with other people’s money). Also, people, who like today think they can make money by buying NFT “art” and selling them higher, but then like all bubbles, the bottom falls out. There is a big difference to loan money to build a house, a material object with real benefits, versus loaning money to keep UBER going.
    Also took me a long time to figure out that the “market” has little to do with the interest rates. Deficits cause high interest rates…OK, Japan? USA – yeah, low interest rates in 2000 with a balanced budget, but how about those record low rates while deficits were sky high for years?

    1. fresno dan



      If a person can see a relationship between interest rates and the amount of the deficit, that is a person who can also see Santa Claus, the Easter Bunny, faeries, Sasquatch, leprechauns AND homo economicus.
      I guess when I see all the nonsense the economics profession generates, I shouldn’t be surprised that something that is so easily and obviously refuted as the loanable funds theory continues to exist. It just shows that humans are prone to believe fables, legends, but always it is difficult to get a man to understand something when his income depends on his not understanding it.

  4. Susan the other

    The value of money should be “anchored to some conventional norm.” So, fiat. But still we are nowhere closer to understanding or maintaining some value of money. We control it with laws like everything else. The best proof of the value of money is belated – established by the result of its use. If the use of money produces a higher level of social good then the money has been made valuable after the fact. But before the fact? Money is nada. So we spin our wheels trying to establish a stable concept of value for money. Which is crazy. But the fact that the very obsession is crazy does serve to explain why trying to maintain a certain “conventional norm” of value is so difficult. There’s probably only one way to establish a beneficial range of value for money – one that does not destroy economies by creating too much inflation or deflation – and that is to spend it consistently into improving society “according to some conventional norm” like good social benefits and welfare; education, etc. That creates a pretty valuable anchor so that the capricious use of money elsewhere doesn’t cause unnecessary harm. I’d think, by now, as we are talking about financing environmental protection and clean-up, that like society, a healthier more viable natural environment creates the same stable quality of “value” – the same level of well-being, and thus also makes money valuable. Scarcity of money is an aberration. Purely synthetic.

    1. aj

      This is a very sincere, succinct comment. Very fairly presented and understandable. Thank you. My thoughts mirror yours but I think it would have taken me several paragraphs to say the same thing.

      1. Susan the other

        thanks, aj. my thinking reflects Yannis Varoufakis. He faced me in this direction a few years back with his detailed thinking. I always knew social spending was good – but I was never sure why.

    2. eg

      Much mischief ensues from thinking about money as an object rather than a system or network. A sovereign fiat currency is the most sophisticated and flexible system of corvee labour ever devised.

      1. Skippy

        Then at the end of the day all money forms are, is just, the numerical symbolism used to satisfy contracts, without the exchange created by contracts the VoM would go to zero and with it your economy – regardless of the form of the token used. But as Susan the other touches on its distribution and that resulting influence on how societies are shaped due to it is a bigger question than any sort of money crankery.

        1. digi_owl

          Pretty much. I think i first heard the idea in one of Steve Keen’s videos, but he himself was quoting someone else. Money is an accounting mechanism. And physical money is accounting without the need for an accountant.

    3. Geoffrey

      As per SusanTheOther, Money- at its most abstract and simple – is the total effort of a society organised by a credit money system to do what that society agrees needs to be done! That is its wonderful potential! As Michael Hudson posits, it was the organisational role of the Temple in ancient Near East societies to issue credit in the form of seeds and tools and take re-payment in grain that ensured a stable food supply, and collateral to that, to ensure roads and administration buildings etc were built and an army maintained, etc. No doubt, looking from a distance of 3,000 years its easier to recognise this primary function and separate it from all the politicking and strife that at went on in and around it. As ever, the problem lies with how is the ‘general welfare’ or ‘overall social good’ to be defined and by whom, in a species driven by personnal or group status relative to others – hence the project descends into what we have always had. And the bigger the society to more remote the outcome from its potential ideal it becomes.

  5. Bart Hansen

    I learned about banks creating money out of thin air from Michael Hudson. When I mentioned this to one of the children I’m not sure he believed me.

    1. rhodium

      It’s all relative. Banks don’t create money so much as they create debt. One person’s debt is another person’s credit and it’s all denominated in money. “Money supply” is just a bizarre way of looking at the amount that base money has been leveraged by the finance sector aka the banks. They leverage the supply which makes deposits grow in tandem with debt levels, but just looking at deposits one would think money is created out of thin air.

      1. tegnost

        One person’s debt is another person’s credit

        I’d say one persons debt is one industrial credit.
        Then you rehypothecate.
        person to person is not what’s going on

      2. skippy

        All money is debt regardless of what monetary theory is applied. The rub about banks – actually contractual clearing houses w/ a side business of making loans to establish income streams with various duration’s with a risk premium some call usury. Funny how the same ideologically driven people pushing UberMarkets were the same sorts that enabled egregious amounts of usury for personal profit far exceeding the risk premium.

        Most of the free banking period/neoclassical 20s dramas were cleaned up during the FDR administration, largely in part by wrangling the U.S. oligarchs into line by state power and then by addressing market functions from a Keynesian-esque approach.

        This was a abomination in the eyes of the U.S. oligarchs at the time and set the stage for agenda we now call neoliberalism – hence the roll back of anything that FDR et al did that got in the way of their preferred social template.

        So when some people bang on about banks et al they seemingly miss out on the fact that laws were removed, public agencies fill with opportunistic flexians maximizing their personal utility, gibberish about private contracts are private caveat emptor, state being subservient to the private sector, etc etc …

  6. aj

    As Warren mostly likes to point out, the “natural” rate of interest is zero. Higher interest rates can help keep the “economy” in check by discouraging borrowing and reducing credit growth. Low interest rates can encourage investment, but without spurring any sort of real demand all that cheap money just goes increased asset prices (stocks, real estate) instead of actually going to something useful.

    1. aj

      took to long to edit. That should say “Warren Mosler” not “Warren mostly”.

  7. MarkT

    “Conventional judgments are those which, by some more or less accidental coalescence of ideas or some natural but hidden means of communication, are adopted by a mass of people who cannot find, and are not really concerned to find, any ‘solid,’ ‘objective,’ and genuinely meaningful basis of judgment… The character of judgments, opinions, and valuations thus arrived at will be a capricious instability. (Shackle 1972, p225)”

    I’ll write that more succinctly: it’s all just an ideology. Based on a belief system, not facts.

    1. Skippy

      The issue at hand is deductive proselytizing verses the ambiguity of the human mind when environmental conditions of risk and reward are not evidence based.

  8. Alex

    Long term interest rates have fallen for over 40 years so all active managers have had to do is to have slightly greater duration than the index and their outperformance was guaranteed.

    I am doubtful whether anything other than Bernanke’s global savings glut can explain the reason for this extraordinary fall.

    I am therefore sceptical of the benefits of the Fed-watching the author has engaged in throughout his career.

    1. Skippy

      I think you would need to go back into the NC archives to better establish an opinion about the author because in case you miss read his post, he’s not a Fed watcher per se, what he is arguing is the effects pre and post central bank mindsets in the market WRT IR and how that effects investment decisions.

      Basically the whole drama about government crowding out or distorting markets divine numerology as Marginalism theory dictates.

      BTW the Bernanke’s thingy has more to do with financial elites playing M-M games or leverage their power over labour for its rights to any productivity.

  9. Patrick Donnelly

    Good article, well done!

    Humans require motivation.

    We are based on the idea of progress through innovation and exploitation.

    Greed or fear are quite adequate and so the ‘hidden hand’ can come into existence, especially if ‘hidden means of communication’ can coordinate the idea of markets. The hidden hand is not a fake market mechanism, it is a form of mercantilism, based on money control. The means of this control are legion and some are quite subtle, clothing fashion for example.

    Who controls? Is it fair to as many as possible, eh Jeremy B?

    We need the true ecology of money rather than ‘economics’, a fake science of naming elements of it?

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