What is an Expectations Theory?

The economic concept of expectations theory involves predictions made from information relating to future interest rates. Economic studies often focus on the collection of data relating to certain events and attempting to determine the directions of an economy or individual future transactions. Expectations theory requires the gathering of information from loan terms for the future lending of capital between two or more parties. From looking at this long-term interest rate information, economists will attempt to predict moves in short-term interest rates.

Most economists use leading and lagging indicators to review and predict the changes in an economy. Leading indicators represent a review of certain parts of an economy in order to determine if economic growth will increase, decrease or stay the same in the future. Common examples of leading indicators include building permits, inventory changes, money supply policies and interest rates for bank loans, which is the focus of expectations theory. Lagging indicators provide information on the changes that have already happened in an economy. A reduction in employee hours worked, increases or decreases in inflation, changes to consumer income and consumer confidence are the most common lagging indicators.

Interest rates attached to loans represent how much an individual or business must pay in order to borrow money. Many individuals and businesses will lock in future loans or credit lines in order to hedge themselves against unfavorable changes to an economy. If borrowers expect interest rates to rise, they will attempt to lock in rates that are closer to current loan terms. The reverse is true if interest rates are higher in the short term. Lenders will desire to lock in lower interest rates because they believe the demand for money will fall, leading to a reduction in loans made to borrowers. Economists use expectations theory to assess if interest rates will change drastically in the next few months, which can indicate growth or contraction in an economy.

Expectations theory can overestimate the increase or decrease of short-term interest rates. Economists may be unable to accurately predict the changes in interest rates, which will result in lower yields of investments, such as bonds. Many corporations will issue bonds as an option to finance major changes in their business operations. Issuing bonds when interest rates fall can result in lower yields, making the investments less attractive to buyers. This will reduce the market for the company’s bonds and may result in the company having to secure other external financing. On the contrary, issuing bonds at low rates that will increase; the yield will also increase with the attractiveness of the bonds as investments for individuals and businesses.