Measuring the Effect of the Zero Lower Bound on Medium- and Longer-Term Interest Rates

The zero lower bound on nominal interest rates has constrained the Federal Reserve's setting of the overnight federal funds rate for over three years running. According to many macroeconomic models, such an extended period of being stuck at the zero bound has important implications for the effectiveness of monetary and fiscal policies. However, economic theory also implies that households' and firms' decisions depend on the entire path of expected future short-term interest rates, not just the current level of the overnight rate. Thus, interest rates with a year or more to maturity are arguably the most relevant for the private sector, and it is unclear to what extent the zero lower bound has affected those rates. In this paper, we propose a novel approach to measure when and to what extent the zero lower bound affects interest rates of any maturity. We compare the sensitivity of interest rates of various maturities to macroeconomic news during periods when short-term interest rates are very low to that during normal times. We find that yields on Treasury securities with six months or less to maturity have been strongly affected by the zero bound during most or all of the period when the federal funds rate was near zero. In stark contrast to this finding, yields with more than two years to maturity have responded to economic news during the past three years in their usual way. One- and two-year Treasury yields represent an intermediate case, being partially constrained by the zero bound over part of the period when the funds rate was near zero. We provide two explanations for these results. First, market participants have consistently expected the zero bound to constrain policy for only about a year into the future, minimizing its effect on longer-term yields. Second, the Federal Reserve's unconventional policy actions may be offsetting the effects of the zero bound on longer-term yields.