A Shadow Rate or a Quadratic Policy Rule? The Best Way to Enforce the Zero Lower Bound in the United States

Andreasen, Martin M.; Meldrum, Andrew C.

doi:10.17016/FEDS.2018.056

Working Paper

A Shadow Rate or a Quadratic Policy Rule? The Best Way to Enforce the Zero Lower Bound in the United States

Abstract: We study whether it is better to enforce the zero lower bound (ZLB) in models of U.S. Treasury yields using a shadow rate model or a quadratic term structure model. We show that the models achieve a similar in-sample fit and perform comparably in matching conditional expectations of future yields. However, when the recent ZLB period is included in the sample, the models ' ability to match conditional expectations away from the ZLB deteriorates because the time-series{{p}}dynamics of the pricing factors change. In addition, neither model provides a reasonable description of conditional volatilities when yields are away from the ZLB.

Keywords: Quadratic term structure models; Sequential regression approach; shadow rate models; Zero lower bound;

JEL Classification: E43; E47; G12;

https://doi.org/10.17016/FEDS.2018.056