Estimating Market Probabilities of Future Interest Rate Changes

The goal of this paper is to estimate the market consensus forecast of future monetary policy development and to quantify the priced-in probability of interest rate changes for different future time horizons. The proposed model uses the current spot money market yield curve and available money market derivative instruments (forward rate agreements, FRAs) and estimates the market probability of interest rate changes up to a 12-month horizon. The estimated probabilities and possible interest rate scenarios are consistent with the observed money market and FRA interest rates. Thus, the model's output has to be interpreted as a description of the current market consensus on future monetary conditions rather than a tool for predicting or setting the correct level of interest rates. The estimation method is based on standard money market data and thus is applicable to any developed financial market. The probability structure of expected interest rate changes in the future could serve as an indicator of the money market reaction to macroeconomic data releases and verbal interventions of monetary authorities. It also allows us to measure the extent of monetary policy predictability and thus to quantify the surprise effects of unexpected monetary policy changes.