Forecasting Interest Rates

One of the frequent but least accurate financial forecasts is a forecast of the future level of interest rates. Typically, for every forecast of increasing interest rates there is a forecast of decreasing rates. When all forecasters unanimously agree on a consensus for future interest rates, they are typically all wrong as rates will inevitably move in exactly the opposite direction. Forecasters are the most accurate at predicting the course of interest rate when they are stable! Experts are notorious for missing the "turning points" when the economic and financial picture changes dramatically and sets the course of interest rates in the opposite direction.

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

Quantitative economic statistical techniques called "econometrics" attempts to model the economy 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. ECONOMETRIC TECHNIQUES

The reason for this inaccuracy is simple. Interest rates reflect human behaviour which is highly complex. This complexity has been compounded by the internationalization of economies and the financial markets. The direction of Canadian and U.S. interest rates is partially set by those of other countries, particularly Germany and Japan. Even governments miss their interest rate forecasts and they have control over their countries' monetary and fiscal policy.

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