Modelling Yields at the Lower Bound Through Regime Shifts

52 Pages Posted: 4 Oct 2019

See all articles by Peter Hördahl

Peter Hördahl

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific

Oreste Tristani

European Central Bank (ECB)

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Date Written: October, 2019

Abstract

We propose a regime-switching approach to deal with the lower bound on nominal interest rates in dynamic term structure modelling. In the “lower bound regime”, the short term rate is expected to remain constant at levels close to the effective lower bound; in the “normal regime”, the short rate interacts with other economic variables in a standard way. State-dependent regime switching probabilities ensure that the likelihood of being in the lower bound regime increases as short rates fall closer to zero. A key advantage of this approach is to capture the gradualism of the monetary policy normalization process following a lower bound episode. The possibility to return to the lower bound regime continues exerting an influence in the early phases of normalization, pulling expected future rates downwards. We apply our model to U.S. data and show that it captures key properties of yields at the lower bound. In spite of its heavier parameterization, the regime-switching model displays a competitive out-of-sample forecasting performance. It can also be used to gauge the risk of a return to the lower bound regime in the future. As of mid-2018, it provides a more benign assessment than alternative measures.

Keywords: monetary policy rate expectations, regime switches, term premia, term structure of interest rates, zero lower bound

JEL Classification: E31, E40, E44, E52, E58, E62, E63

Suggested Citation

Hoerdahl, Peter and Tristani, Oreste, Modelling Yields at the Lower Bound Through Regime Shifts (October, 2019). ECB Working Paper No. 2320, Available at SSRN: https://ssrn.com/abstract=3464245

Peter Hoerdahl (Contact Author)

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific ( email )

78th floor, Two International Finance Centre
8 Finance Street, Central
Hong Kong

Oreste Tristani

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
0049 69 13440 (Phone)
0049 69 1344 6000 (Fax)

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