Forecasting interest rates with shifting endpoints: The role of the functional demographic age distribution

Abstract

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 end-shifting 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 with the random walk model, the DNS model, the DNS model with a simple demographic factor of a middle-to-young 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 one and five years.