Monetary Policy
Forward interest rates

The collapse of fixed exchange rates in Europe and the widening of ERM bands meant that a well-defined intermediate target for monetary policy was lost. In such a situation, the role of indicators are crucial for assessing the state of the economy and the stance of monetary policy. In Discussion Paper No. 1051, Research Fellow Lars Svensson examines the use of forward interest rates as an indicator of monetary policy. He demonstrates that the implied forward interest rate curve (FRC) can be used to indicate market expectations of the time-path of future short-term interest rates, monetary policy, inflation and currency depreciation rates.

Whereas the yield curve can be interpreted as indicating expected future averages of the variables in question, the FRC can be interpreted as indicating their expected future time-paths. Thus, the FRC allows separation of market expectations for the short, medium and long term more easily than the yield curve. This is the main advantage of forward rates for monetary policy analysis: since monetary policy measures typically have effects with long and variable lags, looking beyond the short term is essential. Svensson demonstrates these arguments using the empirical example of Swedish forward rates from 1992-4.

Estimating and Interpreting Forward Interest Rates: Sweden 1992–4
Lars E O Svensson

Discussion Paper No. 1051, October 1994 (IM)