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RAPPORT

Forecasting long-term interest rates

Introducing alternative forecasting methods

The long-term interest rate in the Euro area is an important exogenous input in CPB macro-econometric models to project the world economy and the Dutch economy, so it is important to have a reliable projection for it. However, there were concerns about the CPB practice of forecasting the long-term interest rate, especially over the inconsistency of long-term interest rate projections in the short and medium term. Therefore, this document compares the old CPB practice with several alternative forecasting methods for long-term interest rates, and evaluates these methods on the basis of three criteria: (1) forecasting accuracy, (2) internal consistency between short term and medium term, and (3) internal consistency between forecasting short and long-term interest rates. Alternative forecasting methodologies include: the random walk, the term structure, the forward interest swap rates, and two univariate methods (AR(1) and AR(2)). Additionally, we also construct forecasts based on different combinations of the afore-mentioned methods.

Our empirical analyses show that the random walk always performs the best in terms of forecasting accuracy, whereas the forward swap rates have the highest forecasting accuracy except for statistical models (random walk and both AR models). The results are robust in the post-break period and in the presence of the forecast combination. However, we don’t choose the random walk to project long-term interest rates, because random walk projection tends to lead to an inverted yield curve without any economic background. For the old CPB practice, it does not satisfy evaluation criteria (2) and(3), and it provides lower forecasting accuracy than the forward swap rates.

The forward swap rate is a good predictor that meets all criteria. Compared to the other methods this method has several advantages: first, it is consistent for short term and medium term periods; second, both the short-term and long-term forecasts are based on market information; third, it provides higher forecast accuracy than the old CPB practice; finally, the choice of the swap rate is consistent with the current practice of the European Commission to project the long-term rate. Therefore, starting in CEP 2018 we adopt the forward swap rate to project long-term interest rates.

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