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Shadow Interest Rates and the Stance of U.S. Monetary Policy

"Current policy may be easier than often perceived".
James Bullard, President and CEO, FRB-St. Louis
Federal Reserve Bank of St. Louis, 8 November 2012

In November 2012, James Bullard, President and CEO of the Federal Reserve Bank of St- Louis gave a very interesting presentation on the concept of "Shadow Interest Rates"  and the current stance of U.S. Monetary Policy.

He asks the question whether US monetary policy might be "too easy", and if there is an alternative method to measure  it,  given that we have been a zero nominal-rate environment since 2008.

He then calculates a short-term "Shadow Rate" to develop measure monetary policy in a zero-rate environment, and compare it with the actual target rate since 2008.

His conclusion is that current U.S. monetary policy may be considerably easier than commonly understood, and substantially easier than the policy stance recommended by the Taylor-Rule.

Excerpts from James Bullard's presentation:

"Is Current U.S. Monetary Policy "Too Easy"?

"Main Idea"

  • "Some recent research suggests that current U.S. monetary policy may be considerably easier than commonly understood.
  • In particular, the current U.S. policy stance may be substantially easier than the policy stance recommended by commonly-used monetary policy feedback rules.
  • This research is based on ideas in mathematical finance."

"A shadow rate"

  • "The level of nominal short-term interest rates is conventionally taken to indicate the stance of policy. Lower values are described as "easier" policy.
  • The FOMC's policy rate has been effectively pegged near zero since December of 2008.
  • How should the monetary policy stance be described given this development? A math finance answer: Construct a "shadow rate."

(...)


"Nominal interest rates cannot fall materially below zero."

"The Krippner calculation of a shadow short-term nominal interest rate allows us to compare a measure of actual policy against the recommended policy from a standard policy rule."

The chart below compares the Federal Fund rate with the Shadow Rate (Kripper model) and the Taylor rule prescription since 2006:

Recommended policy versus actual policy: effective rate, Taylor rule and the shadow rate:

Source: Federal Reserve Bank of St. Louis, November 2012
Click on the chart for a larger view

"Current policy may be easier than often perceived"

  • "According to these estimates, the shadow policy rate is currently more than 300 basis points lower than the rate recommended by the Taylor (1999) rule.
  • This suggests that actual U.S. monetary policy may currently be easier than the recommendations from that particular rule."

"More Implications"

  • "In 2009, policy may have been too tight relative to the recommended Taylor (1999) rate. The FOMC at that point had not taken many of the unconventional policy actions and did not expect to do so.
  • The actual policy stance as measured by the shadow rate has recently been more volatile than during the pre-2008 era. This may be because monetary policy has been harder to interpret during the period of the zero lower bound."

A closer look: the shadow rate and the Fed's forward guidance

The shadow rate and the Fed's forward guidance
Source: Federal Reserve Bank of St. Louis, November 2012
Click on the chart for a larger view

A closer look: the shadow rate, QE and operation Twist

Source: Federal Reserve Bank of St. Louis, November 2012
Click on the chart for a larger view

"The value of unconventional policy"

  • "The Krippner study gives us one way to evaluate recent unconventional policy actions by the FOMC. Significant unconventional policy actions at times seem to conform well with movements in the shadow policy rate. Times of less conformity may indicate an ineffective policy action.
  • The accumulation of policy actions since 2008 has generally been associated with a continuing decline in the level of the shadow rate¡Xthat is, an easier and easier policy stance."

Link to the original presentation

Link to the St. Louis Fed