Official Cash Rate to remain restrictive at 5.50 percent

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What do forward interest and exchange rates tell us?

Yuong Ha, Michael Reddell

This article looks at how one month forward rates for 90 day bank bill interest rates, the $NZ/$US exchange rate, the trade-weighted index (TWI) and the monetary conditions index (MCI) have behaved over the period between January 1989 and March 1998.1 The results suggest that, for a one month horizon: • forward rates tell us very little about where the actual rate will be. This result is not too surprising and reflects the fact that financial market prices can be volatile and hence difficult to predict, particularly over the short term; • forward rates have persistently under-estimated actual changes in future market prices in a way that has been linked to the cycles in those prices. Perhaps part of the explanation for this pattern is that both central banks and the financial markets have persistently underestimated changes in inflation, as they have sought to learn about the process that drives inflation; • forward interest rates and forward MCIs reasonably reflect what the market expects to happen; • forward exchange rates, however, do not look like average market expectations. Over the past nine years, forward exchange rates have nearly always priced in a depreciation of the future exchange rate.