Understanding Policy Rates at the Zero Lower Bound: Insights from a Bayesian Shadow Rate Model

Abstract

Term structure models are routinely used by central banks to assess the impact of their communication on market participants' expectations for interest rates. But some recent studies have shown that the traditional term structure models may be misleading when policy rates are at the zero lower bound, one reason being that such models cannot reproduce the stylized fact that once policy rates reach the ZLB they tend to remain there for a prolonged period. A consensus has now emerged that shadow rate models, pioneered by Black (1995), can solve this problem. The thesis is that the "shadow rate" (the short-term interest rate that would prevail in the absence of the ZLB) can stay in negative territory for long time spans even when the actual rate remains close to the ZLB. Since they are strongly non-linear, shadow rate models are especially hard to estimate, and to date the literature has used only approximate methods to this end. Instead, we propose an exact Bayesian method of estimation and apply it to developments in the euro and dollar yield curves since the end of the 1990s. Our estimates confirm and provide a quantitative measure of quantify the significant divergence of monetary policies between the euro area and the US: between 2009 and 2013, the shadow rate was much lower in the US than in the euro area, and since then the opposite has been the case. At the end of our sample period in January 2015, according to our model the most likely date for the the first increase in policy rates was estimated to be mid-2015 in the US and 2020 in the euro area.

The Non-Standard Monetary Policy Measures of the ECB: Motivations, Effectiveness and Risks

“…Belke, Gros and Osowski (2017) argue that, without controlling for the common downward trend in interest rates across the major advanced economies, the impact of QE is bound to be over-estimated.21 The so called shadow rate may also be used to assess the degree of monetary policy accommodation associated with unconventional measures when the policy rates are at their effective lower bound(Wu and Xia, 2016) Pericoli and Taboga (2015). find that the shadow rate in the euro area fell deeply into negative territory ahead of the launch of the APP.22 Event studies may deliver biased estimates of the impact of policy announcements(Greenlaw et al, 2018), as initial market overreactions (based on expectations about the policy moves) are often corrected later on, once the decisions are actually taken.…”

The Bank Lending Channel of Conventional and Unconventional Monetary Policy

“…Third, we substitute the Shadow rate -MRO spread as a measure of unconventional monetary policy with a measure of the slope of the yield curve, calculated as the difference between the 10year IRS and the MRO rate (see Baumeister and Benati, 2013). This experiment rules out possible concerns related to the possibility that the point estimates of the shadow-rate are model-dependent (Pericoli and Taboga, 2015). Finally, we include two other indicators that may capture additional effects of unconventional policy that could have not be captured by the Shadow rate: a measure of excess liquidity as calculated from the Eurosystem's balance sheet, which has been used in a number of studies based on macro data Boeckx et al, 2014;Bulligan and Emiliozzi, 2016); and a dummy variable to capture the effect of the OMT announcement (see Altavilla et al, 2014).…”

“…Once the ZLB is reached, the central bank can alter the monetary stance by influencing long-term interest rates through forward guidance as well as through direct or indirect market interventions. The shadow rate provides a measure of the monetary stance at the ZLB by parsimoniously summarizing the information about the monetary stance that is embedded in the term structure of interest rates (Pericoli and Taboga, 2015). Therefore movements of the shadow rate tend to be broadly correlated with the events related to the adoption of non-standard monetary policy measures (Krippner, 2013a).…”

“…For unconventional policy, we use the spread between the "shadow rate" measure developed by Krippner (2013aKrippner ( , 2013b and the MRO rate. The shadow rate provides a measure of the monetary stance at the ZLB by parsimoniously summarizing the information about the monetary stance that is embedded in the term structure of interest rates (Pericoli and Taboga, 2015). Movements of the shadow rate tend to be broadly correlated with the events related to the adoption of non-standard monetary policy measures (Krippner, 2013a) and potentially capture the effects related to both the announcement and the implementation of non-standard measures.…”

The Bank Lending Channel of Conventional and Unconventional Monetary Policy

“…For unconventional policy, we use the spread between the "shadow rate" measure developed by Krippner (2013aKrippner ( , 2013b and the MRO rate. The shadow rate provides a measure of the monetary stance at the ZLB by parsimoniously summarizing the information about the monetary stance that is embedded in the term structure of interest rates (Pericoli and Taboga 2015). Movements of the shadow rate tend to be broadly correlated with the events related to the adoption of nonstandard monetary policy measures (Krippner 2013a).…”