Is the market always right? Improving federal funds rate forecasts by adjusting for the term premium

Release date
Michael Callaghan
ISSN 2230‐5505

Financial market prices contain valuable information about market participants’ expectations. Information on market participants’ expectations of future growth, inflation, and interest rates may help policy-makers reflect on the plausibility of their own forecast assumptions, and understand the likely market reaction to any policy announcement.

However, the existence of risk premiums will bias the information content of financial market prices. For interest rate securities, the term premium will create a wedge between market participants’ expectation of the future path of the policy rate and the price being traded. Therefore, in order to extract the ‘true’ underlying policy expectations of market participants, market pricing needs to be adjusted for the term premium.

In theory, adjusting for the term premium should improve forecast performance on average, given that it provides an unbiased measure of market participants’ expectations. I therefore use a popular term structure model to test the out-of-sample forecast performance of US market pricing with and without a term premium adjustment. I focus on the short-end of the yield curve, up to two years, as it is directly relevant for policy-makers and financial market commentators.

The results suggest that the short-term forecasting performance of US interest rates over the medium term can be improved by adjusting for the term premium in zero-coupon rates and overnight index swap rates. The current negative term premium implies that market participants at present expect the future policy rate in the United States to be higher than that implied by market prices. I also show how the model can be applied to monitor expectations for the future path of the federal funds rate at a daily frequency.

The analysis has important implications for policy-makers and financial commentators. Adjusting for the term premium should provide a better measure of market participants’ actual expectations for the future path of the policy rate, and as such can improve forecast performance over the medium term.