A comment on Wu and Xia (2015), and the case for two-factor Shadow Short Rates
Shadow Short Rates (SSRs) estimated from shadow/lower-bound term structure models (SLMs) can be useful for monitoring of the stance of unconventional monetary policy and for quantitative analysis, but only if they are relatively robust. I show from several perspectives that SSRs from three-factor SLMs, which includes Wu and Xia (2015) SSRs, are not robust, and how that arises from the inherent flexibility of three-factor SLMs. Such SSRs should therefore be avoided. However, I also show that estimated SSRs from two-factor SLMs are relatively robust. Hence, two-factor SLM SSRs appear to be good candidates for monitoring and quantitative analysis, but ideally with appropriate robustness checks including alternative monetary policy metrics.
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