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Unlocking the Secrets of the U.S. Interest Rate: How to Forecast Like a Pro

20 July 2023 • 6 mins read

CUHK scholar shares insights on U.S. interest rate outlook and how to forecast it through a structural framework

By Pan Jingyi, Principal Writer, China Business Knowledge@CUHK

Following a series of 10 consecutive hikes, the U.S. Federal Reserve voted to pause its aggressive campaign of interest rate increases in mid-June. The Federal Open Market Committee (FOMC) decided to maintain its benchmark lending rate at a range of 5.0 to 5.25 percent. However, the rate-setting committee also hinted at the possibility of further monetary tightening before the end of the year.

Given that the United States is the world’s largest economy and the U.S. dollar is the world’s primary reserve currency, fluctuations in the U.S. interest rate have immediate effects on global markets. Acting as the central bank of the nation, the Federal Reserve’s primary objective is to maintain a stable U.S. economy. When the economy booms, issues such as inflation and asset bubbles can arise and threaten economic stability. To cool down an overheated economy, the Fed has traditionally stepped in and raised interest rates. When interest rates are raised, the costs of borrowing money (e.g., mortgage, car loans, and credit cards) increase, and consumers tend to pull back on spending. This can reduce the supply of money in circulation, which is a way to lower inflation.

“The most difficult but rewarding strategy to forecast the U.S. interest rate is to ‘do your own economic analysis’, which would help people ‘beat the market’ and gain more significant returns.”

Dr. Andrew Yuen

New-York-U.S.-economy — Acting as the central bank of the nation, the Federal Reserve’s primary objective is to maintain a stable U.S. economy.

As the U.S. interest rate directly affects people’s spending habits and investment returns, it would be helpful to forecast whether the U.S. government will increase or decrease it in the coming month. An educated forecast can help consumers find clues and make wiser investment decisions.

Andrew Yuen, Senior Lecturer at the Department of Decision Sciences and Managerial Economics, The Chinese University of Hong Kong (CUHK) Business School, shared his thoughts on these questions in a masterclass for the school’s EMBA programme titled “U.S. Interest Rate Outlook 2023” which took place in May 2023 .

Utilising Public Information Effectively

According to Dr. Yuen, people with varying degrees of economic knowledge can use different methods to forecast the U.S. interest rate. “The easiest and most effective way for those who don’t have any knowledge about economics is to look at the financial market data and follow the predictions of investment analysts,” he said. To obtain the latest probabilities of the U.S. interest rates, he recommended using the CME FedWatch Tool.

Andrew-Yuen-cuhk — During an EMBA master class, Dr. Yuen shared his insights regarding the outlook of U.S. interests.

However, rather than just obtaining information passively from the market, people can pursue a more advanced strategy. Dr. Yuen proposed analysing information from the FOMC. The FOMC is the branch of the Federal Reserve System that determines the U.S. interest rate. By analysing the information on the FOMC website, such as their meeting dates, after-meeting statements and projection materials, people can gain insights into the future trends of the U.S. interest rate.

Dr. Yuen illustrated how people can extract key information by comparing different statements from the committee. He highlighted a sentence in the March statement: “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy.” He explained that this sentence indicated a further increase of the interest rate in FOMC’s May meeting. This was confirmed when the committee members met in May. Noticeably, the same sentence was deleted in the May statement, which suggested that the FOMC would not increase the interest rate in the upcoming meeting. As he anticipated, the Fed voted to maintain the interest rate in June, validating the initial inference.

Besides information from the FOMC website, people should also pay attention to what the FOMC members say in news reports. “The views of the voting members are quite important, especially [those of] Jerome Powell, the Chair of the Federal Reserve,” Dr. Yuen said.

Understanding the Causes of Interest Rate Fluctuations

U.S.-Feceral-Reserve — The Federal Open Market Committee (FOMC) is the branch of the Federal Reserve System that determines the U.S. interest rate.

In addition to the two strategies mentioned above, Dr. Yuen noted that the most difficult but rewarding strategy to forecast the U.S. interest rate is to “do your own economic analysis”, which would help people “beat the market” and gain more significant returns.

Before attempting to make a forecast, however, one must first understand the primary objectives of the FOMC — maximum employment and stable prices. Therefore, Dr. Yuen said, individuals should examine the labour market and inflation trend to forecast the interest rate. “If the unemployment rate is very high, the interest rate will be reduced, and if the inflation rate is very high, the interest rate will be increased,” he explained.

food-price-inflation — As an abstract concept, inflation can be reflected in commodity prices.

While the FOMC’s decision-making process is theoretically straightforward, conducting one’s own forecast can be quite challenging. “When you forecast the interest rate, you need to forecast the inflation rate and unemployment rate in the future, just like the Fed would,” said Dr. Yuen. He further explained that interest rate decisions are forward-looking because any monetary policy takes time to become effective.

Dr. Yuen then discussed some indicators that individuals can use to analyse inflation trends. As an abstract concept, inflation can be reflected in commodity prices. He noted that housing, food and services are three major factors influencing inflation. More specifically, if the latest rental cost is trending down in the coming year, inflation is likely to also decrease. As such, the Fed would not increase the interest rate hastily. Likewise, decreasing food prices is also a sign of lowering inflation. Other indicators of U.S. inflation include the U.S. Producer Price Index (PPI) and China’s inflation figures. In general, interest rates will likely decrease if inflation rates decrease, Dr. Yuen summarised.

“Besides commodity prices, the U.S. labour market trends also affect the interest rate,” he said, adding that people should pay attention to U.S. salaries. If salaries decrease, people can expect lower inflation and lower interest rates.

Global Economic Growth: Inflation or Double Dip Recession?

In the masterclass, Dr. Yuen shared his latest forecast of the U.S. interest rate for the end of 2023. After his sharing, he emphasised the importance of adjusting the figure based on the latest developments in the market. “The most important thing here isn’t for me to tell you my conclusion, but to show you how to conduct your own analysis.”

Dr. Yuen also encouraged attendees to put theory into practice. “Practice makes perfect. Try to apply what you have learned in this class and see if those methods are effective,” he advised.