Modelling yields at the lower bound through regime shifts

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.