When Monetary Policy Reaches The Floor: Theory And Applications Preliminary

The relationship between inflation, unemployment and the Federal Reserve Target rate is not linear. This is obvious when the Target rate reaches its lower bound. But it is also the case more generally as the documented responses of bond and derivative prices to economic news depend on the state of the economy. We introduce the new class of Discrete Choice Dynamic Term Structure [DCDTS] models that account for these non-linearities while guaranteeing positive interest rates. This class of model results from seeing the monetary policy function as a discrete choice problem where the latent indicator and the latent threshold points are stochastic. Empirically, we focus on the response of the Central Bank, and the responses of interest rates and interest rate derivatives, to inflation and unemployment news and find significant non-linearities. In contrast with regime-switching or quadratic affine models, sensitivity parameters are not latent but can be interpreted easily as functions of observable state variables: inflation and employment