What Really Drives Long-Term Interest Rates?

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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