Question

What tools are available for forecasting interest rates? How is this used/important?

Answer 1

Tools are available for forecasting interest rates are :

1. Purchasing Power Parity

The purchasing power parity (PPP) is perhaps the most popular method due to its indoctrination in most economic textbooks. The PPP forecasting approach is based on the theoretical law of one price, which states that identical goods in different countries should have identical prices.

According to purchasing power parity, a pencil in Canada should be the same price as a pencil in the United States after taking into account the exchange rate and excluding transaction and shipping costs. In other words, there should be no arbitrage opportunity for someone to buy inexpensive pencils in one country and sell them in another for a profit.

2. Relative Economic Strength

As the name may suggest, the relative economic strength approach looks at the strength of economic growth in different countries in order to forecast the direction of exchange rates. The rationale behind this approach is based on the idea that a strong economic environment and potentially high growth are more likely to attract investments from foreign investors. And, in order to purchase investments in the desired country, an investor would have to purchase the country's currency—creating increased demand that should cause the currency to appreciate.

The relative economic strength method doesn't forecast what the exchange rate should be, unlike the PPP approach. Rather, this approach gives the investor a general sense of whether a currency is going to appreciate or depreciate and an overall feel for the strength of the movement. It is typically used in combination with other forecasting methods to produce a complete result.

3. Econometric Models of Forecasting Exchange Rates

Another common method used to forecast exchange rates involves gathering factors that might affect currency movements and creating a model that relates these variables to the exchange rate. The factors used in econometric models are typically based on economic theory, but any variable can be added if it is believed to significantly influence the exchange rate.

As an example, suppose that a forecaster for a Canadian company has been tasked with forecasting the USD/CAD exchange rate over the next year. They believe an econometric model would be a good method to use and has researched factors they think affect the exchange rate. From their research and analysis, they conclude the factors that are most influential are: the interest rate differential between the U.S. and Canada (INT), the difference in GDP growth rates (GDP), and income growth rate (IGR) differences between the two countries. The econometric model they come up with is shown as:

It is important because forecasting interest rates allows economists to predict the movement of interest rates and inform regulatory bodies and investment managers accordingly. By having an informed prediction of the movement of interest rates, markets can preemptively adapt to changing conditions.Currency exchange rate forecasts help brokers and businesses make better decisions.