Which Shadow knows?

One area of wonky economic research this blog has been following is on Shadow rates, which aims to boil down the current stance of unconventional monetary policy into an effective policy rate equivalent. Because these are for the most part constrained by zero (or meaningfully below zero), shadow rates have more recently been negative.  This post provides some background.

There isn't a consensus on exactly the best way to measure what the shadow rate is, with the BIS weighing in with new estimates.  The method and results are quite different from the Wu and Xia estimates, for which updates are available here.

The big difference in methodology is that the BIS estimates use a wider range of factors to determine shadow rates, including data on money supply and the change in the Fed's balance sheet.

It is the rate of change in the Fed's balance sheet which is found to have the biggest impact on the shadow rate once the effective funds rate hits zero. On the contrary, the Wu and Xia method is more about gleaning this information from the yield curve rather than explicitly including these variables.

To me the Wu and Xia method makes more sense, as the BIS estimates appear too heavily influenced by changes in the Fed balance sheet, with the level of securities held appearing much less important. I also tend to think that the degree to which the current and future expected size of the Fed's balance sheet is important to markets is priced into yield curves via term premia.

It's interesting that the Wu and Xia estimates have become increasingly negative in the last few months, which appears to be partly due to the steepening of the yield curve at the non-zero shorter end of the curve.  The spread from 2-5 year bonds has widened a little as bonds have sold off in the last week or so.

While the 2-5 year portion of the curve has steepened, the longer end of the curve has remained at low levels, with spreads narrowing.

Using the Wu and Xia model, this suggests that the stance of monetary policy has actually gotten easier since the start of 2014.

This isn't so much deliberate, with the Fed for the most part holding the course since FOMC Chair Yellen took over this year.  But markets have reacted to the poor growth data seen in Q1.

What is a little surprising in this context is that inflation expectations have made a meaningful shift higher since mid-April, which coincided with a particularly dovish speech from Chair Yellen rather than signs of stronger inflation.

The combination of better inflation expectations and low interest rates would be welcome by the Fed in the face of weaker growth at this stage, especially as they continue to taper QE.