Monetary Policy, Macro Factors, and the Term Structure at the Zero Lower Bound

Abstract

We describe the joint dynamics of bond yields, monetary policy and macroeconomic variables within a no-arbitrage affine term structure framework while explicitly modeling the zero lower bound (ZLB) using the shadow rate methodology. We include data on the unemployment gap and inflation to build a more comprehensive representation of the true stance of monetary policy, incorporating the influences of unconventional policy instruments introduced to combat the Great Recession. The model makes it possible to examine the effects of policy in an environment which solves the ZLB issue. We find that shadow rate models that incorporate macroeconomic factors suggest a more negative shadow rate and a more extended projection of the future duration of the ZLB episode than models that include only financial data. Also, including the macro data through a standard monetary VAR allows the model to better capture the dynamics of the shift in policy focus towards targeting longer-term yields. Finally, the shadow rate produces a proxy for the stance of policy that suggests the unconventional policy programs achieved a substantial accommodation, in excess of that prescribed by a standard policy rule.