Shadow short rate and monetary policy in the Euro area

Abstract

Empirical modelling of the monetary policy effects using conventional linear econometric models is put to a great test when interest rates approach the zero-lower bound. A possible remedy recently proposed in the literature is to introduce a shadow short rate (SSR) obtained from the yield curve model as an alternative monetary policy measure. This paper examines the usefulness of shadow rates as a policy stance measure for the Euro area. Moreover, the SSR can be used to study the country-specific monetary policy stance. We incorporate the shadow short rate in a standard vector autoregressive analysis to study the effects of monetary policy shocks both at the level of the Euro area and for two periphery EA countries, Italy and Spain, that endured significant financial stress during the crisis. Our analysis shows that monetary policy shocks identified form the SSR produce similar macro responses as shocks identified from the standard policy rate. The Euro area shocks can directly translate to a corresponding change in the country-specific financing conditions in the periphery, whereas the reverse effect is limited. The historical decomposition of the stochastic component of the SSR series shows that the unconventional policy measures were effective in stabilising the sovereign crisis in 2011, however, their relatively limited quantity provided only a weak stimulus to the economy.