Modeling Short Term Interest Rates: A Comparison of Methodologies

The celebrated Taylor rule methodology has established that the decisions made by the Federal Open Market Committee concerning possible changes in short term interest rates reflected in Fed funds are influenced by deviations from a desired level of inflation and from potential output. The Taylor rule determines the future interest rate and is one among several methodologies than can be used to predict future short term interest rates. In this study we use four competing methodologies that model the behavior of short term interest rates. These methodologies are: time series, Taylor, econometric and neural network. Using monthly data from 1958 to the end of 2005 we distinguish between sample and out-of-sample sets to train, evaluate, and compare the models' effectiveness.