Estimating and Interpreting Interest Rate Expectations

Abstract

Expectations about future interest rates and inflation influence economic developments. For example, market expectations of higher inflation may themselves result in higher inflation, for instance through higher pay increases. Households’ choice between consumption and saving is influenced by their expectations concerning future interest rates. A high level of short-term interest rates will probably have less of a contractionary effect on economic activity if the market believes this to be a transitory phenomenon than if it is expected to persist. Inflation expectations also reflect whether market participants are confident that economic policy will result in low inflation over time. One important source of information about these expectations is the market’s pricing of interest-bearing securities with different maturities. This article describes the method used by Norges Bank for estimating interest rate expectations, and discusses how these estimates may be interpreted. In addition, the importance of various premia will be considered, and some alternative approaches for estimating interest rate expectations will be discussed.