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Why Bother Forecasting Interest Rates?

Forecasting interest rates is an involved process that takes a multitude of different factors into consideration. This article outlines this process and the uses for interest rate forecasts.

Why Bother Forecasting Interest Rates?

Forecasting interest rates allows economists to predict the movement of interest rates and inform regulatory bodies and investment managers accordingly. By having an informed prediction of the movement of interest rates, markets can preemptively adapt to changing conditions.

The Process of Forecasting Interest Rates

Techniques

The process of forecasting interest rates is notoriously inaccurate. For every forecast of increasing rates there is one of decreasing rates. Whenever forecasters reach a consensus regarding future interest rates, they are typically all wrong, as rates inevitably move in the opposite direction. While experts are effective at predicting the course of interest rates during periods of stability, they often fail to forecast major “turning points” in the economic and financial landscape.

Economists use a variety of techniques to forecast interest rates. The most basic is to use economics and history as a guide to make a judgment about what is an appropriate level of interest rates and what their future course should be given the state of the economy. Since most economists disagree on how the economy works, or what economic history means, this is more difficult than it seems.

Econometrics

Quantitative economic statistical techniques called “econometrics” attempts to model the economy and supplement the process of forecasting interest rates by using mathematical and statistical relationships. A comprehensive model of the economy might have hundreds of equations and many variables. The problem with these techniques is that while they might have a “high explanatory power” or be “robust” historically against “back-tested” data after the fact, they are very poor at explaining the future before the fact.

The reason for this inaccuracy is simple. Interest rates reflect human behavior that is highly complex. This complexity has been compounded by the internationalization of economies and the financial markets. Even governments miss their interest rate forecasts, and they have control over their countries’ monetary and fiscal policy.

Schools of Economic Thought

Economists generally fall into three groups: monetarists, Keynesians and classical.

   1. Monetarists believe that the money supply and monetary policy explain the economy, interest rates and inflation;

2. Keynesians believe that the linkage between government fiscal policy, the financial markets and interest rates explains the economy and inflation;

3. Classical economists believe both monetary policy and fiscal policy have an impact.

Forecasting Interest Rates: Implications

While the process of forecasting interest rates is complex, it is also inaccurate. The results of an analysis of potential future interest rates should only be taken as a guide since, as we have seen, there is very little we can do to reliably predict movements and fluctuates in interest rates.

4 years ago

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