Can forward rates be used to improve interest rate forecasts?

Abstract

We evaluate the extent to which the explanatory power detected in the term structure in
different markets and countries can actually be used to produce sensible forecasts of future short-term
interest rates. Specifically, in spite of the forecasting connotation of the unbiasedness property of
forward rates, actual evaluation of their forecasting performance has received scant attention in the
literature on the term structure. We use monthly data for 1978-1998 on interest rates on Eurodeposits
on the US dollar, yen, Deutsche mark, British pound, Spanish peseta, French franc, Italian lira and
Swiss franc, comparing forecasts obtained from forward rates to those obtained from univariate
autoregressions. By themselves, forward rates produce better one-step ahead forecasts, as well as
better once-and-for all forecasts of 1-month interest rates over a full year horizon than those obtained
from the own past of interest rates. The gain in one-step ahead forecasting disappears for longer
maturities, although forward rates still produce better once-and-for all predictions of 3- and 6-month
interest rates than univariate autoregressions for a number of currencies.