Economics in central banking: Leo Krippner

His work on term structure modelling has helped central bank policy-makers to track the effects of unconventional policies and it raises many interesting possibilities for future research

Close to a decade on, economists are still working to readjust their intellectual frameworks in the wake of the global financial crisis. Central Banking's award for economics has already recognised some of those seeking to redesign the old frameworks, while this year the award goes to an economist who has sought to improve our understanding of 'unconventional' monetary policy – an area that has become more conventional by the day, demanding analysis to match.

Leo Krippner, a senior adviser in the economics department at the Reserve Bank of New Zealand (RBNZ), has led the debate on how central bank economists should think about unconventional policy, through his work on term structure modelling. His ideas aim to quantify the effects of monetary policy below the zero lower bound – and in so doing recognise that policy in the 'new normal' is driven not only by short rates but also by the shape of the entire yield curve – with expectations on how it will evolve.

"It was an idea I had when I was doing my thesis on term structure modelling," Krippner says. "I thought at the time that using bond options to allow for the lower bound, essentially options to hold currency, would be a straightforward way of ensuring that yields are not allowed to evolve through the lower bound."

By pricing the option on holding physical currency, which yields no interest, Krippner was able to produce a hypothetical 'shadow short rate' that would hold if physical currency were not available. The shadow rate gives a simple indication of the stance of policy, even when short rates have hit the lower bound and central banks have turned to unconventional measures.

Krippner finished the thesis in 2008. In 2011, he found himself working on a yield curve model for the US and realised standard models would not make sense with rates at the zero lower bound. He mentioned his ideas on the shadow rate to his manager, who said: "Well, you better get on that quickly, because rates might not remain at the lower bound for much longer!"

Of course, in the intervening five years, many more economies have hit the lower bound. Krippner has since developed his ideas in a series of papers and a book published in 2015 by Palgrave Macmillan. The RBNZ now publishes his estimates of the US shadow short rate on its website, alongside the MatLab code for his calculations.


Krippner has also developed the shadow short rate into a metric he calls "effective monetary stimulus" (EMS). This measures the area between the expected path of the shadow rate (the policy rate if above zero) and the estimated neutral rate, giving a forward-looking view of the strength of monetary stimulus.

EMS is "more meaningful as a number that people in the economy react to", as people do not actually transact at the shadow short rate, he says. It is also less affected by questions of model specification and can be calculated without the need to estimate a model at all.

Krippner says many central banks are already using his tools for policy analysis, adding that the central bankers with whom he has spoken have tended to be the most interested in EMS. "For quantitative analysis, I think EMS is going to be something people are more comfortable with," he says, pointing to its robustness.

Krippner's measures are now in the toolbox of most central banks since the global financial crisis and serve to directly inform policymakers
Sandra Eickmeier, Deutsche Bundesbank

Sandra Eickmeier, an economist at the Deutsche Bundesbank who has co-authored research with Krippner, says his ideas are becoming widely adopted. "Krippner's measures are now in the toolbox of most central banks since the global financial crisis and serve to directly inform policymakers," she says. "Moreover, papers using his measures and developing his measures further have been published in highly ranked academic journals."

Krippner's ideas are popular in Europe, and the Bundesbank published a paper he co-authored with Arne Halberstadt in December. His ideas have also been taken up on the other side of the Atlantic, with Federal Reserve Bank of St Louis president James Bullard highlighting the shadow rate as a useful rule of thumb in a speech in 2013.

Krippner says he was not the first to come up with his option-based method of dealing with the zero lower bound. Fischer Black's 1995 paper Interest rates as options presented a similar idea, but as later research by Jens Christensen and Glenn Rudebusch at the Federal Reserve points out, Black's method imposed an "extreme computational burden". Krippner's code is much more practical to run. The most challenging element of writing the code was ensuring the outputs matched the expressions from the standard term structure and bond option specifications, he says.

"Krippner's work was pivotal for a new literature branch that looks at yield curve-based metrics of the monetary policy stance at times when standard monetary policy is constrained by the lower bound," says an economist at the European Central Bank. "His work has been highly influential in the academic term structure literature, and it has been especially valuable for central bank departments that focus on modelling and analysing the term structure from a monetary policy perspective."

The research also opens up exciting possibilities for future work. One idea that Krippner would like to examine further is how term structure models interact with the macro-economy – how growth and inflation impact the term structure, and vice versa. He also notes that a particularly important area for small, open economies such as New Zealand is the exchange rate.

Economists have "been around the bush" lately, trying to figure out reasons for the failure of covered interest parity, Krippner says. He wonders if policymakers and market watchers may have been focusing too much on the short rate when the whole yield curve matters.

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