Abstract

We find empirical evidence of a possible structural break in the relationship between the foreign holdings of U.S. Treasury securities and the U.S. long-term interest rate occurring at the time when U.S. monetary policy became constrained at the zero-lower bound (ZLB). The estimated marginal effect of the foreign holdings ratio on the U.S. long-term interest rate, particularly its long-run effect, appears to have become stronger during the ZLB regime than it was before. We argue that the leading explanation of this apparent break is the nonlinearity introduced by the ZLB. Motivated by theory, we propose a flexible nonlinear specification to deal with the ZLB — a threshold single-equation error-correction model splitting the sample in two regimes, pre-ZLB and ZLB, which replaces the observed Fed Funds rate with a shadow Fed Funds rate derived from a Tobit-IV model to incorporate a broader measure of the stance of monetary policy. With this setup, we find no significant structural break in the relationship between foreign holdings and long-term rates at the ZLB. Therefore, we argue that the ZLB is a leading cause of the apparent shift in the empirical relationship. We also show that the estimated effects are not just statistically-significant, but also economically-significant. Through counterfactual analysis, we show that changes in China’s holdings of U.S. Treasury securities played an important role in explaining the 2004-2006 interest rate conundrum period and kept the long-term interest rate from going ever lower in the recent ZLB period.

Talk to us

Join us for a 30 min session where you can share your feedback and ask us any queries you have

Schedule a call

Disclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.