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The United States have interest rates close to zero, and it will stay like this of a few more years according to the Federal Reserve. This has also been the case in Japan for more than a decade. When the interest rate is not informative, it because very difficult to establish when the central bank policy is tight or loose. A Taylor rule may tell you that it should have negative interest rates, but because they cannot be negative, we cannot measure the impact of the unconventional tools the central bank may have used.
Leo Krippner finds a way to tease the monetary stance out of the yield curve. The issue is that the interest rates cannot go negative no matter what the central bank does because there is always the option to hold cash instead of bonds. This gives Krippner two ideas. First, one can then decompose a bond into an option to hold cash and another security, which may have a negative return (a shadow interest rate). The return of this security measures the monetary stance. The second is that the yield curve can help in pricing the option. For example, if long yields are very low the option has a lot more value than if the yield curve is steep.
This decomposition is then executed for the United States. The results are quite fascinating. For example, over the past five years, the shadow interest rate is at -5%, meaning that the Fed is doing a lot to help the economy. Whether this is enough is another question, but it does not look like it is just doing nothing effective. Also, one can easily match movements of the shadow interest rate with actions of the Fed. Sadly, these actions seems to have rather short-lived impacts, beyond keeping the shadow interest rate at roughly -5%.
Wednesday, October 31, 2012
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Thanks for your comments on my research – it’s a nice summary of the issue and the paper. It’s worth adding the important caveat that the effective economic stimulus associated with the shadow short rate becomes more complex when it moves below zero, because the negative shadow interest rates implied for short maturities are obviously not actual rates available to the economy. For example, easing from 5% to 4% gives more economic stimulus (because interest rates across the entire yield curve move down) than easing from -4% to -5% (because short-maturity interest rates can’t move any lower). I have some additional work in the pipeline to help quantify that concept (essentially a liquidity effect as a function of the shadow short rate), or some related discussion is available in “A model for interest rates near the zero lower bound: An overview and discussion”, Reserve Bank of New Zealand Analytical Note, 2012/05, pp. 6-8. But in any case, the Fed can still "ease" (and have been doing something, as you mention) even after the policy rate became constrained by the zero lower bound. Cheers, Leo
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