The Information Content of the Short End of the Term Structure of Interest Rates

Market determined interest rates are important indicators for monetary policy since they can give a measure of market expectations of future policy. Although previous work in the Bank has estimated yield curves from gilt prices and found that these give useful information about long-term expectations, the value of such yield curves at short horizons - below two years - is open to question. This paper analyses two related questions on short-term interest rate expectations: 1) is there useful information in shorter-term interest rates and 2) are some interest rates more informative than others? In particular, it compares the relative performance of the short end of the Bank yield curve and traded LIMEAN rates at various maturities. Its benchmark of comparison is a practical one - it assesses, ex post, how well the different measures predicted future shorter-term interest rates (eg how well six-month interest rates predict three-month interest rates in three months time). It finds that the yield curve contains some information at short horizons but that it is less reliable than the information from LIMEAN rates. This suggests that the current Bank approach of only analysing yield curves above two-year horizons and using other information to measure short-term interest rate expectations is probably correct. Although interest rate futures are a widely used measure of market expectations the information they contain is not directly comparable to the yield curve.