Forecasting Interest Rates with Shifting Endpoints : The Role of the Demographic Age Structure

An extended dynamic Nelson-Siegel (DNS) model is developed with an additional functional demographic (FD) factor that considers the overall demographic age distribution as a persistent long-run driving force. The FD factor in the extended DNS model improves the accuracy of the yield curve forecast by reducing both bias and variance compared to the random walk model, the DNS model, the DNS model with a simple demographic factor of a middle-to-young (MY) age ratio, and a benchmark end-shifting model. The model with an unspanned FD factor performs substantially better than the alternative models for most maturities at forecast horizons between 1 and 5 years