Knowledge of such expectations helps the MPC to predict whether a particular policy decision is likely to surprise market participants, and what their short-term response is likely to be to a given decision. Expectations of future levels of official rates also play a key role in determining the current stance of monetary policy. However, many agents in the economy are also affected by changes in longer-term interest rates. Changes in these longer-term interest rates depend to a considerable extent on expectations of future official rates. So the Bank needs to have some understanding of expectations of future policy rates, in order to monitor and assess changes in current monetary conditions.
Forward rates are the most commonly used measure of interest rate expectations.
In principle, we want to derive forward rates that correspond to future two-week Bank repo rates. Unfortunately, however, there is no instrument that allows us to do this exactly. So we have to estimate forward rates from the sterling money market instruments that are actually traded. This article argues that first, forward rates estimated from money market instruments are biased estimates of expectations of future Bank repo rates because of term, credit and liquidity premia, as well as contract specification differences. And second, no particular money market instrument is likely to provide a 'best' indication of Bank repo rate expectations at all maturities.