Monetary Policy Expectations at the Zero Lower Bound

Abstract

We show that conventional dynamic term structure models (DTSMs) estimated on recent U.S. data severely violate the zero lower bound (ZLB) on nominal interest rates and deliver poor forecasts of future short rates. In contrast, shadow-rate DTSMs account for the ZLB by construction, capture the resulting distributional asymmetry of future short rates, and achieve good forecast performance. These models provide more accurate estimates of the most likely path for future monetary policy-including the timing of policy liftoff from the ZLB and the pace of subsequent policy tightening. We also demonstrate the benefits of including macroeconomic factors in a shadow-rate DTSM when yields are constrained near the ZLB.

The predictive density simulation of the yield curve with a zero lower bound

“…First, the ZLB has mattered since late 2008. To show this, we follow Bauer and Rudebusch (2014), and plot the posterior probability of the negative one-month-ahead three-month bond yields over the out-of-sample period from the DNS and NDNS models, as shown in Fig. 5.…”

“…Christensen and Rudebusch (2013) demonstrate that in a near-ZLB yield environment, a shadow-rate model within the arbitrage-free Nelson-Siegel framework provides superior in-sample fit performance. Recently, Bauer and Rudebusch (2014) proved that a shadow rate model can capture the asymmetry of predictive short rates, and that this is critical to forecasting the timing of short-rate lift-off. Although these models have a strong theoretical foundation and provide economically interpretable quantities, their computational burden for estimation is very high because of the severely nonlinear restrictions on the factor-loading structure.…”

On the influence of US monetary policy on crude oil price volatility

“…By including T-Spread-Exp in our model, we expect to take into account another important monetary policy transmission mechanism. In fact, managing expectations is a critical tool, particularly when the short-term interest rate is close to the zero lower bound, i.e., when conventional monetary policy can no longer be enacted to provide monetary accommodation (Bauer and Rudebusch 2013). By managing policy expectations (forward guidance) monetary policy makers could provide additional monetary stimulus when the short-term rate is at zero lower bound.…”

“…The zero bound induces a positive and increasingly significant bias in expected nominal rates when the short-term interest rate is close to this frontier. According to Bauer and Rudebusch (2013), "the closer the policy rate is to zero the more it becomes a one way bet with rates staying the same or going up -but not down -in the future." However, these considerations are beyond the aim of this paper and further research should be undertaken to investigate this issue.…”

“…Finally, a third specification relies on term spread, computed as the difference between the 10-year Treasury bond and the 3-month Treasury bill. However, even if term spread incorporates the expectation on the long-run monetary policy, this proxy also embeds a time-varying term and risk premium component that can make it difficult to disentangle the expected path of monetary policy (Bauer and Rudebusch 2013). Therefore, in a further specification we take directly into account the effect of expectations by including the expectations data from the SPF as an additional explanatory variable in the term spread model.…”