Our economy forecasts include a number of variables where we judge the best way to produce a forecast is to use the future values that are implicit in the prices of various financial market instruments. Since these reflect the collective views of the large number of investors in each market, it seems unlikely that our own forecasts could systematically outperform the market. We use this approach to forecast oil prices, interest rates and the exchange rate. We also forecast equity prices by using the latest market values and other assumptions. The rest of the forecast is then in effect conditioned on these implied financial market expectations of the most likely future path of these variables.

Financial market indicators can be volatile, responding to news and events from day to day. We control for this by basing our forecasts on the market-implied expectations over a 10-day window – a period that aims to be short enough to capture the latest market view, but long enough to be less susceptible to day-to-day volatility. At the start of the forecast process, we agree a forecast timetable with the Treasury that includes the dates at which we will take financial market expectations. Usually, we set the 10-day window for our final economy forecast to be as close as possible to the point where we close down the forecast to everything but the effects of new policies. We could move away from that if there were events that we might expect to distort indicators of financial market sentiment around that time.

The main conditioning assumptions we use in our forecast are:

  • Oil prices

    The average path implied by the Brent crude futures curve for the 10 days to our collection date is used for the first two years of our forecast, after which we hold the price flat in real terms using a price index based on major countries’ CPI inflation. This methodology is informed by IMF analysis that suggests that the futures curve is not the best predictor of oil prices beyond a two-year horizon. That may be partly due to the oil futures market beyond the two-year horizon not being sufficiently liquid to give a reliable representation of market expectations for oil prices beyond that point.

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  • UK interest rates

    The expected paths for a number of measures of UK interest rates – notably Bank Rate (set by the Bank of England) and gilt yields (the market-determined interest rate paid on government bonds) are derived from financial market instruments including sterling overnight indexed swap (OIS) rates. As described above, we take an average of the market-implied path for each of the 10 days up to and including our collection date for each of these variables.

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  • World interest rates

    We take a trade-weighted average across USA, Canada, Japan and Euro-area collected from interest rate futures markets, similar to the process for UK interest rates. Again, we take an average of the market-implied path for each of the 10 days up to and including the collection date.

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  • Exchange rates

    The short-term paths of exchange rates are determined by the relevant futures curves, which are assumed to give the most accurate reflection of current economic prospects. Beyond the first two quarters, the trade-weighted sterling effective exchange rate index (ERI) is assumed to follow a path implied by the uncovered interest parity condition – where exchange rates are assumed to adjust so as to remove the possibility of making arbitrage profits if global interest rates followed the paths implied by market expectations. We take the same approach with both the sterling/dollar and sterling/euro exchange rate.

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  • Equity prices

    Our equity prices forecast is constructed in a slightly different way, since we do not use futures markets. Instead, the starting point is a 10 working day average of the FTSE All-Share index up to and including the collection date. Equity prices are then assumed to grow in line with our forecast for nominal GDP over the forecast period.

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