‘Gap Model’ on Interest Rates Improves Forecast Accuracy: SF Fed
(Bloomberg) -- Bridging the gap between current and long-run levels of interest rates by considering the underlying trend in inflation expectations and the equilibrium real rate “can substantially improve the accuracy’’ of forecasts, San Francisco Fed research adviser Michael Bauer writes in economic letter released Monday.
- Same principles used in economic forecasts can be applied to rates; results are relevant to modeling and “understanding interest rates more generally’’
- Successful forecasts require three parts: current value or “nowcast,’’ long-run trend estimate, and a framework to guide transition from current to long-run level
- Trend in interest rates can be viewed as the sum of inflation expectations and inflation-adjusted, “real’’ rates
- Given historical reversion to trend, it’s a “reasonable assumption’’ that 20% of remaining gap is closed each quarter; precise speed of trend reversion “typically not crucial’’ for forecasting performance
- Gap model forecasts on average “much more accurate’’ than other methods for both long (1971-2016) and short period (1988-2016)
- For shorter sample, absolute error of gap model averaged 0.8ppts vs Blue Chip forecasts that averaged 1.9ppts
- Despite small sample size, differences are “statistically significant’’
- Interest rates “vary widely from day to day’’; hard to link them to economic fundamentals, like monetary or fiscal policy
- “It is crucially important to account for shifts in macroeconomic trends when estimating risk premiums in bond markets, modeling how fundamental drivers such as economic growth and monetary policy affect the yield curve, and for understanding the historical evolution of interest rates over the long run’’
To contact the reporter on this story: Anna Windemuth in New York at awindemuth1@bloomberg.net To contact the editors responsible for this story: Boris Korby at bkorby1@bloomberg.net Vivien Lou Chen
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