What are interest rates really?

I recently had someone ask me to explain what interest rates are.  At first I was stumped, thinking ‘you know, the rate interest’, but then it occurred to me that wasn’t really the question.  My acquaintance was really asking, “what is the function of interest rates” and are they arbitrary?  Great questions with an interesting answer.

Too Much Information

The much-maligned ‘Efficient Market Hypothesis’ proposes that market prices already incorporate all known information, and that only new information can make prices change, other than in a completely random fashion.  There are some problems with this idea, but in the very short term, market participants sure act like it’s true.  That’s why they sit huddled in front of screens for every data release, and then furiously trade the market as soon as the data comes out.  As a strategist, I always found the flurry to be pretty amusing – just look at how much data there is between this morning (August 26th, 2008) and next Friday’s employment report: