Natural Rate in a Shadow Rate Term Structure Model

Abstract

We propose a shadow rate no-arbitrage DTSM with drifting trends to estimate the natural rate of interest. With the shadow rate reflecting overall financial market condition (Wu and Zhang (2019)), its long run forecast (in real term), defined as our natural rate, provides a useful measure against which monetary policy stance may be assessed. We apply our model to treasury yields data in the United States, the United Kingdom, and Germany for the sample from November 1972 to December 2019. We find that all three natural rates have been declining since as early as the 1990s and have all turn negative in the most recent few years. Furthermore, there is a strong co-movement among the three natural rates indicating that global factors contribute significantly to the natural rate declining dynamics, corroborating findings in Holston et al. (2017). The term premium estimates from our model are quite stationary and are significantly and positively correlated with several inflation uncertainty measures, consistent with Wright (2011).