Publication - Below the zero lower bound: a shadow-rate term structure model for the euro area
In June 2014, the Governing Council of the ECB decided to decrease the deposit facility rate, one of its key policy rates, from zero to -10 basis points. Another rate cut to -20 basis points followed in September. Swap and bond yields of short- to medium-term maturities eventually turned negative as well. The removal of the zero lower bound raises the question of how to analyze the driving forces and exploit the information content of the yield curve in an unprecedented negative-rate environment.
We develop an econometric model to analyse the euro-area yield curve from 1999 to mid-2015. The model belongs to the class of arbitrage-free ‘shadow-rate’ term structure models, which feature a lower bound on interest rates at any point in time. In contrast to most of the literature, which typically embodies a fixed lower bound of (slightly above) zero, our model caters for the possibility of an occasionally changing and possibly negative effective lower bound. We analytically inspect the mechanism by which such a change in the bound affects the yield curve. In contrast to most of the related studies, we use survey information to cross-check our results.
We find that the market perception of the effective lower bound on euro-area interest rates decreased from marginally above zero to -11 basis points in September 2014. Such a decrease in the effective lower bound enables current and future rates to be negative, while they have been constrained to be positive before. We illustrate that the decrease of the short end of the yield curve following the September 2014 ECB rate cut can be largely attributed to a decline in the market-perceived effective lower bound. As an implication for monetary policy, if the central bank manages to decrease the market’s view of the lower bound location, it can thereby decrease current and expected interest rates, which will in turn decrease forward and spot rates – even in a situation where the lower bound is not yet binding. Therefore, the lower bound itself can be interpreted as a ‘monetary policy parameter’.
We also demonstrate that the model’s forecasts are far more closely in line with corresponding survey forecasts and capture the decline in yield volatility far better than a popular benchmark model that ignores the presence of a lower bound. We estimate that since mid-2012, the median horizon after which future short rates are once again expected to exceed the level of 25 basis points has ranged between 18 and 62 months. Finally, we emphasize that quantifying this time span is highly dependent on the estimated level of the lower bound, with a similar sensitivity also being evident when disentangling the expectations and term premia components embedded in bond yields.
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