Forward rates are extremely limited predictors of actual interest rates. This isn't particularly surprising, given the multitude of determinant factors for interest rates or the nature and use of forward rates. The imperfections of forward rate forecasts tend to be most glaring before the business cycle begins a boom or bust cycle.

The Determinants of Interest Rates

Generally speaking, interest rates depend on the supply and demand for interest-bearing financial instruments. There are three major influences on the supply and demand of interest rates: liquidity preference, the difference between the demand for past and future consumption, and the premium demanded for assuming market risk.

For example, if inflation is expected to increase in the future, individual and institutional investors may demand higher rates from their financial instruments. Businesses might increase offered interest rates on issues if they need more capital than is available to spend on future expansion.

Banks may raise interest rates if they want more deposits and lower them if they want less. The opposite is true for bank lending; rates increase if banks want to discourage borrowing and decrease if they want to encourage borrowing.

In modern mixed economies, interest rates are heavily influenced by central bank policy. Rates tend to fall when the Federal Reserve pursues expansionary monetary policy and contract when it pursues contractionary monetary policy.

Limits of Forward Rates

Because there are so many complex, uncertain and interconnected influences on interest rates, it is very hard to predict where rates will land in the future.

Most forward rate calculations tell investors a lot more about how spot rate curves are set today. Even though longer-term spot rates are adjusted based on future expectations, their accuracy is limited to the forecasting ability of present market actors (and Federal Open Market Committee (FOMC) policy or other artificial manipulations).

Forward rates are intended to coordinate futures contracts so that they are competitive with other financial market transactions. There is a component of future forecasting involved, but it is ancillary rather than primary.

  1. How do I convert a spot rate to a forward rate?

    The spot rate shows the cost of executing a financial transaction today, while the forward rate provides the cost of executing ... Read Answer >>
  2. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
  3. How does a high discount rate affect the economy?

    A high discount rate causes loans to be more expensive and encourages people to save more money. This could be considered ... Read Answer >>
  4. What is the Difference Between a Forward Rate and a Spot Rate?

    The forward rate is the settlement price of a forward contract, while the spot rate is the settlement price of a spot contract. Read Answer >>
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