Estimating and Interpreting Forward Interest Rates: Sweden 1992-1994

Estimated and Interpreting Forward Interest Rates: Sweden 1992-1994
by Lars E. O. Svensson

Forward interest rates are interest rates on investment and loans that
start at a future date--the settlement date--and last to a date further into
the future--the maturity date. The purpose of this paper is to demonstrate
the use of forward interest rates as a monetary policy indicator. Both the
estimation and the interpretation of forward rates are discussed, using data
from Sweden during the eventful period 1992-1994 as an example.

There is an increased need for monetary policy indicators when flexible
exchange rates replace fixed exchange rates. In Europe, in particular, the
collapse of fixed exchange rates and the widening of ERM bands mean that a
well-defined intermediate target for monetary policy has been lost. In this
situation, regardless of whether a new intermediate target is introduced,
the role of indicators will be crucial for assessing the state of the
economy and the stance of monetary policy, and for deciding whether the
instrument of monetary policy is on track to achieve the goal of monetary

Although the use of yield curves is standard in monetary policy
analysis, central banks, such as the Board of Governors of the Federal
Reserve System, the Bank of England, and the Sveriges Riksbank, have only
recently started to use forward interest rates--as, of course, only one
indicator among the many that are needed--for monetary policy purposes.

In the absence of a full set of forward markets, implied forward
interest rates need to be estimated from the standard yield curve of
existing financial instruments, usually treasury bills and government bonds.
For financial analysis, the estimation of forward rates is done with a
number of different methods--some rather complex--to achieve sufficient
precision. For monetary policy analysis, the demand for precision is
arguably less, which can be traded for increased robustness and simplicity
of the estimation method. The paper discusses and uses an estimation method
that is simple and robust but appears to have a precision well beyond what
is needed for monetary policy purposes.

Forward interest rates can, under specified assumptions, be interpreted
as indicating market expectations of future short-term interest rates,
inflation rates and currency depreciation rates. Although forward rates
contain the same information as the standard yield curve, they present the
information in a way more easily interpreted for monetary policy purposes.
Whereas the yield curve can be interpreted as expected future averages of
the variables in focus, the forward rate curve can be interpreted as
indicating the expected future time path of these variables. Therefore, the
forward rate curve more easily allows a separation of expectations for the
short, medium, and long term than does the yield curve.

As an example, the paper uses forward rates to interpret Swedish
monetary policy during the May 1992-June 1994 period.