Forecasting Interest Rates

1. Forecasting Interest Rates Valeria Feandeiro – Manuela Schenardi – Alberto Depedri – Diego Bodini

2. 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 DO INTEREST RATES MEAN?

3. 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.

4. MONETARIST THREE ECONOMIC THEORIES : KEYNESIANS 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 sale-proceeds resulting from demand”, depends on how consumption and saving are linked to the production of an investment. 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. 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.

5. 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.

6. DETERMINANTS OF ASSET DEMAND

7. DETERMINANTS OF ASSET SUPPLY

8. 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

9. 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? WhatisQUANTITATIVE-easing?

10. Until February 2010, the BOE had engaged in an active policy of quantitative-easing 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. An example: the bank of england

11. Source: http://www.bankofengland.co.uk

12. On 21 September 2010, the FOMC decided to keep the federal funds rate at 0-0.25% 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. currenttrends in QUANTITATIVE-easing

13. 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. currenttrends in QUANTITATIVE-easing

14. 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 europeancentralbank

15. THE TERM OF STRUCTURE OF INTEREST RATES

16. 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.

17. 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. EMPIRICAL FACTS

18. HOW CAN WE EXPLAIN THE STRUCTURE OF INTEREST RATES: THREE THEORIES The liquidity premium theory: is the expectations theory plus a liquidity premium. This theory assumes that investors prefer shorter-term bonds because they bear less interest-rate risk. Therefore, investors need to be offered a positive liquidity premium for them to hold longer-term bonds. The expectations theory: says that interest rates on a long- term bond will equal an average of the short-term interest rates that people expect to occur over the life of a long-term bond The market segmentation theory: analyses the markets for different-maturity bonds as completely segmented and separated, with no effects from expected returns on other bonds with other maturities.

19. The Liquidity Premium Theory and making forecasts from the yield curve. UK, USA, Japan and the Eurozone yield curves. Forecasting interest rates in the next 6 months

21. Eurozone yield curve (week ending 15 October 2010) UK yield curve (week ending 15 October 2010) UK benchmark gilt yields Eurozone benchmark yields Japan yield curve (week ending 15 October 2010) US yield curve (week ending 15 October 2010) Japanese benchmark yields US benchmark treasury yields