Measuring interest rate expectations from market yields: topical issues

Learning market participants’ policy rate expectations is a major issue for central banks. The underlying reason for this is that the interest rate expectations of market participants may themselves contain information on market participants’ perceptions of the economic prospects, which decision-makers might want to incorporate into their own assessment of the outlook. Market participants’ expectations, however, cannot be observed directly and are difficult to quantify. Of the two most common approaches, we will discuss in detail the one where we infer market expectations from the prices of the financial instruments which are closely related to expectations. In properly functioning, liquid markets we can infer market participants’ expectations of future interest rates from the prices of and returns on government securities and inter-bank transactions. Before the onset of the financial crisis, BUBOR (Budapest Inter-bank Offered Rate) reflected market participants’ expectations of the interest rate relatively reliably, but since the deepening of the crisis, this has changed for a number of reasons, which we will also seek to pinpoint. The fact that BUBOR no longer reflects real market expectations, i.e. it distorts them, is all the more important as this measure serves as a benchmark rate for other financial products, among other things, for corporate loans. The loss of the information content of BUBOR means that the yield curve derived from returns on inter-bank market instruments provides a more accurate measure of market expectations if we exclude data on BUBOR fixings. Nevertheless, forward rate agreements (FRAs) settled on BUBOR remain suitable for the quantification of market participants’ expectations. However, in interpreting these, it is important that, in addition to credit and liquidity risk premia, the bias caused by BUBOR should also be taken into consideration.