by Frank Shostak
Mises.org
Mainstream thinking considers the central bank a key factor in the determination of interest rates. By setting short-term interest rates, the central bank, it is argued, can influence the entire interest rate structure by creating expectations about the future course of its interest rate policy.
In this way of thinking, the long-term rate is an average of current and expected short-term interest rates. If today’s one-year rate is 4 percent and the next year’s one-year rate is expected to be 5 percent, then the two-year rate today should be 4.5 percent ((4%+5%)/2=4.5%).
Conversely, if today’s one-year rate is 4 percent and the next year’s one-year rate expected to be 3 percent, then the two-year rate today should be 3.5 percent ((4%+3%)/2=3.5%).