Forward Rates, Monetary Policy and the Economic Cycle

Abstract

The short end of the yield curve incorporates essential pieces of information to forecast the next decisions of Central Banks, but in a biased manner. I therefore propose a new method to forecast the Fed and the ECB decision rate by correcting the swap rates for their cyclical economic premium, using an affine term structure model. The corrected yields offer a higher out-of-sample forecasting power than the yields themselves. They also deliver forecast that are either comparable or better than those obtained with a Factor Augmented VAR, underlying the fact that yields are likely to contain at least as much information regarding monetary policy as in a pure economic dataset.

Keywords: risk premium, affine models, FAVAR, Central Bank forecasting, forward rates

JEL Classification: C53, E44, E47