European Monetary Policy and the Yield Curve

From the Economist last week:

Since the financial crisis the European Central Bank (ECB) has ploughed a solitary course, reflecting its unique status as a monetary authority without a state. While other big central banks, notably America’s Federal Reserve, adopted quantitative easing– buying government bonds by creating money– to stimulate recovery, the ECB relied mainly on lowering interest rates and providing unlimited liquidity to banks on longer terms and against worse collateral. But as the Fed phases out its asset-buying programme in 2014, it may be the ECB’s turn to become unorthodox.

By one measure, the ECB may already be there.

I have earlier described research by UCSD Ph.D. candidate Dora Xia and University of Chicago Professor Cynthia Wu that can be used to characterize the dynamics of the term structure of interest rates and policy actions taken by the Federal Reserve over the last five years. Their approach is based on the idea that there are some latent factors that determine changes over time in interest rates of different maturities. The dynamics of these factors follow simple linear equations. During normal times the overnight interest rate is a particular linear function of these factors. The idea is to continue to use that same linear function through the recent episode, even though that calculation in today’s environment turns out to produce a negative number. That number, which corresponds to the overnight interest rate when it is positive, but can still be calculated even if negative, is referred to as the “shadow” short-term interest rate in this class of models. The actual overnight interest rate is the maximum of the shadow rate and a positive lower bound on interest rates. Arbitrage conditions (expected returns and risk should be priced consistently across assets) can then be used to calculate current implied values or to forecast future values for any interest rate of any maturity. The Wu-Xia model does a very good job at describing the recent U.S. data, and their series for the shadow rate offers a useful way to summarize the effects of some of the unconventional policy measures adopted by the U.S. Federal Reserve over the last several years.

Wu and Xia have recently extended their approach to calculate implied shadow rates for the U.K. and the euro area. The shadow rate for the U.K. plunged into negative territory after the Bank of England implemented its quantitative easing policy in March of 2009.

Shadow rate and official bank rate for the U.K. Source: Xia (2014).


Interestingly, the ECB’s shadow rate moved into negative territory with the expanded longer-term refinancing operations (LTROs) in December 2011. The euro shadow rate saw a subsequent drop with ECB President Mario Draghi’s July 2012 commitment (and September 2012 follow-up bond purchases) to do whatever it takes to preserve the euro.

Shadow rate and official policy rates for the euro area. Source: Xia (2014).


These new series can be a useful tool for updating models that have been fit to historical values for the fed funds rate for the U.S., the Bank Rate for the U.K., or the ECB refinancing rate. Research at the Federal Reserve Bank of Atlanta illustrates the promise of this approach. The Wu-Xia estimates of the shadow rate for the U.S., U.K., and euro area are regularly updated online for anyone to use.

This piece is cross-posted from Econbrowser with permission.