FORECASTING INTEREST
RATES
Valeria Feandeiro – Manuela Schenardi – Alberto Depedri – Diego Bodini
WHAT DO INTEREST RATES MEAN?
An INTEREST RATE is the rate at which interest is paid
by a borrower for the use of money that they borrow
from a lender. Interest rates are fundamental to a
capitalist society and those are normally expressed
as a percentage rate over the period of one year.
WHAT DOES ECONOMIC FORECASTING MEAN?
Forecasting can be
considered a method or a
technique for estimating
many future aspects of a
business or other
operations.
Forecasting Interest rates means to
predict how the level of interest rates
change time after time (daily, weekly,
monthly etc....). Forecasting is based on
the use of statistical models and utilizing
variables some of which are indicators like
GDP and many others.
THREE ECONOMIC THEORIES :
CLASSIC
The pillar on which the classic
theory is based on is known as
Say's Law, this states that “
supply creates own demand”.
We can see Say's Law in two
ways:
1.the claim that the total value
of output is equal to the sum of
income earned in production
and is a result of a national
income accounting identity;
2.the “costs of output are
always covered in the
aggregate by the saleproceeds resulting from
demand”, depends on how
consumption and saving are
linked to the production of an
investment.
KEYNESIANS
Keynesian theory argues
that private sector
decisions sometimes lead
to inefficient
macroeconomic outcomes.
Keynesian theory states
that government
intervention is necessary to
ensure an active and
vibrant economy; and for
this government should
stimulate demand for goods
and services to encourage
economic growth.
MONETARIST
Is an economic concept
which contends that
changes in the money
supply are the most
important determinants of
the rate of economic growth
and the behavior of
business cycle.
Monetarists argue that if the
Money supply rises faster
than the growth of national
income there will be inflation,
but if the money supply
increases in line with
inflation, there will be no
inflation.
WHY DO INTEREST RATES CHANGE: INDICATORS &
FACTORS
GROSS DOMESTIC PRODUCT: GDP measures the output of goods and services produced by labour
and property located in a country. It is the most important economic indicator.
CONSUMER PRICE INDEX: CPI is a measure of the average change over time in the prices paid by
urban consumers for a fixed market basket of consumer goods and services. It is the most important
measure of inflation. A higher than expected CPI or an increasing trend is inflationary and may cause
bond prices to fall and yields to rise, likewise, a lower than expected CPI may cause interest rates to
fall.
PRODUCER PRICE INDEX: PPI is a family of indexes that measures the average change over time in
the selling prices received by domestic producers of goods and services, that measure price change
from the perspective of the seller. It can be volatile.
EMPLOYMENT SITUATION:
Payroll employment Together with the unemployment rate, this is the most important indicator of current
economic trends each month; a higher than expected monthly increase or an increasing trend
upwards, is considered inflationary, and can cause bond prices to fall and yields and interest rates to
rise. A smaller than expected rise can cause yields and interest rates to fall.
Unemployment rate the unemployment rate is a lagging indicator. It shows the number of unemployed
people by occupation, industry, duration of unemployment and reasons for unemployment. A lower
than expected unemployment rate or declining trend is considered inflationary and could cause bond
prices to fall and yields and interest rates to rise.
DETERMINANTS OF ASSET DEMAND
DETERMINANTS OF ASSET SUPPLY
MONETARY POLICY AND HOW IT AFFECTS THE
CREDIT MARKET
WHAT IS QUANTITATIVE-EASING?
AN EXAMPLE: THE BANK OF ENGLAND
CURRENT TRENDS IN QUANTITATIVE-EASING
THE EUROPEAN CENTRAL BANK
WHAT IS QUANTITATIVE-EASING?

Quantitative-easing is the process whereby the central bank increases the
quantity of money in the economy by injecting money directly into the economy.
They achieve this by means of open market operations.

Both the Federal Reserve Bank (FOMC) and the Bank of Enngland (BOE) have
engaged in monetary-easing policies as part of their response to the financial
crisis.

The Bank of Japan has also adopted this policy now.

Why have they adopted this policy? How does it work? What does it hope to
achieve? How does it affect the credit markets?
AN EXAMPLE: THE BANK OF ENGLAND

Until February 2010, the BOE had engaged in an active policy of quantitativeeasing by pursuing open market operations, i.e. the purchase of UK government
bonds (gilts).

Up to now (October 2010), they have increased their stock of asset purchases to
£200 billion.

It adopted a monetary-easing policy throughout 2009 because:
1. GDP growth was very low;
2. UK spending was at an all-time low;
3. There was risk of very low inflation;
4. Official bank rate was already very low (0.5%);
5. They needed to increase inflation to the 2% target;
6. By purchasing gilts they could increase the quanitity of money in the economy
rapidly and reduce the cost of borrowing.

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Source: http://www.bankofengland.co.uk
CURRENT TRENDS IN QUANTITATIVE-EASING

On 21 September 2010, the FOMC decided to keep the federal funds rate at 00.25% and hinted at the high probability of adopting further quantitative-easing.

In the minutes to the meeting held on 21 September 2010, the FOMC stated
that, “if economic growth remained too slow to make satisfactory progress
toward reducing the unemployment rate or if inflation continued to come in below
levels consistent with the FOMC's dual mandate, it would be appropriate to
provide additional monetary policy accommodation.”… “Meeting participants
discussed several possible approaches to providing additional accommodation
but focused primarily on further purchases of longer-term Treasury securities
and on possible steps to affect inflation expectations.”

There has been a lot of speculation of a potential deflation in the US economy
which has prompted further monetary-easing.
CURRENT TRENDS IN QUANTITATIVE-EASING

On 7 October 2010, the BOE decided that it would maintain interest rates at
0.5% and maintain the stock of asset purchases at £200 billion.

In the minutes to the meeting held on 7 October 2010, the BOE stated that even
though CPI inflation was beyond the 2% target (currently at about 3.1% for
September), this was short-term. Earnings and money growth still remained
weak and consumer spending would most likely stay low given proposed
government austerity measures.

On 5 October 2010, The Bank of Japan lowered its benchmark interest rate to a
range of 0 percent to 0.1 percent. The Bank of Japan also said it would set up a
temporary fund of 5 trillion yen, 3.5 trillion of which would be set aside to
purchase Japanese government bonds.
THE EUROPEAN CENTRAL BANK

On 7 October 2010, the ECB stated that the official rate would stay at 1%.

Unlike the FOMC and BOE, the ECB is generally more concerned about the rate
of inflation and price stability.

The harmonized index of consumer prices (HICP), which is the Inflation index
representing the 16 member states, is used to define and assess price stability
in the euro area as a whole in quantitative terms.

The HICP is currently just under 2% (about 1.8%) which is in line with the ECB
mandate.
THE TERM OF STRUCTURE OF INTEREST RATES
YIELD CURVE
Yield curves show the relationship of yields (interest
rates) for bonds with different terms to maturity
but having equal credit quality. So the logical
assumption is that generally all bonds issued by
the US treasury have the same credit quality.
They are all risk free because there is no default
risk.
EMPIRICAL FACTS
We must show three empirical facts to understand well the yield curve:
1) Interest rates on bond of different maturities move
together over time
2) When short-term interest rates are low, yield curves are
more likely to have an upward slope; when short-term
interest rates are high the curves slope downward and
are inverted.
3) Yield curves almost always slope upward.
HOW CAN WE EXPLAIN THE STRUCTURE OF INTEREST RATES:
THREE THEORIES
The expectations
theory:
The market
segmentation theory:
The liquidity premium
theory:
is the expectations theory
says that interest rates
analyses the markets
plus a liquidity premium.
on a long- term bond
for different-maturity
This theory assumes that
will equal an average of
bonds as completely
investors prefer shorterthe short-term interest
segmented and
term bonds because they
rates that people expect
separated, with no
to occur over the life of effects from expected bear less interest-rate risk.
a long-term bond
returns on other bonds Therefore, investors need
to be offered a positive
with other maturities.
liquidity premium for them
to hold longer-term bonds.
FORECASTING INTEREST RATES IN THE NEXT 6
MONTHS
The Liquidity Premium Theory and making forecasts from the yield curve.
UK, USA, Japan and the Eurozone yield curves.
UK yield curve (week ending 15 October 2010)
UK benchmark gilt yields
Japan yield curve (week ending 15 October 2010)
Japanese benchmark yields
Eurozone yield curve (week ending 15 October 2010)
Eurozone benchmark yields
US yield curve (week ending 15 October 2010)
US benchmark treasury yields
COUNTRY
Official Interest Rate
Credit Market Yields
USA
0 – 0.25%
Slight decrease
UK
0.5%
Slight decrease
JAPAN
0 – 0.1%
Slight decrease
EUROZONE
1%
Remain the same