The negative interest rate policy and the yield curve

Summary

Focus

The European Central Bank (ECB) has cut interest rates four times under zero since 2014. This paper extracts the market expectations embedded in the euro area's yield curve to study the impact of the ECB's negative rate policy on that yield curve.

Contribution

Negative policy rates are a relatively new tool for central banks and it is important to understand their implications, particularly for financial markets, which are  important intermediaries in the transmission of monetary policy actions to the real economy.

This paper proposes a new model to extract the impact of negative interest rates on the yield curve which fits the data much better than alternative models. This new model introduces two latent state variables that capture the immediate and longer horizon monetary policy stances, respectively, in order to describe the rich dynamics playing out at the short end of the yield curve. These two policy indicators guide the time variations of the effective lower bound of interest rates which, in turn, govern the shape of the short end of the yield curve.

Findings

We use the model to extract the market's expectations of the ECB's negative interest rates from the yield curve. We find that the cuts in June 2014, when the ECB first moved into negative territory, and December 2015 were expected one month ahead. However, the September 2014 cut was unanticipated. Most interestingly, the March 2016 cut was expected four months ahead of time.

We then evaluate the impact of negative interest rates on the yield curve with a hypothetical analysis. We find that, if the central bank had committed to an expansionary policy in both the short and long run in June 2017, the two-year yield would have decreased by 0.2% and the long term yield by 0.16%.

Abstract

We extract the market's expectations about the ECB's negative interest rate policy from the euro area's yield curve and study its impact on the yield curve. To capture the rich dynamics taking place at the short end of the yield curve, we introduce two policy indicators that summarise the immediate and longer-horizon future monetary policy stances. The ECB has cut interest rates four times under zero. We find that the June 2014 and December 2015 cuts were expected one month ahead but that the September 2014 cut was unanticipated. Most interestingly, the March 2016 cut was expected four months ahead of the actual cut.

JEL classification: E43, E52, E58

Keywords: negative interest rate policy, effective lower bound, term structure of interest rates, shadow rate term structure model, regime-switching model