Forecasting Inflation with a Zero Lower Bound or Negative Interest Rates: Evidence from Point and Density Forecasts

This paper investigates the predictive power of the shadow rate for the inflation rate in countries with a zero lower bound (the US, the UK and Canada) and in those with negative rates (Japan, the Euro Area and Switzerland). Using shadow rates obtained from two different models (the Wu-Xia (2016) and the Krippner (2015a) ones) and for different lower bound parameters we compare the out-of-sample forecasting performance of an inflation model including a shadow rate interaction term with a benchmark one excluding it. Both specifications are estimated by OLS (Ordinary Least Squares) and includes a range of macroeconomic factors computed by means of principal component analysis. Both point and density forecasts of the inflation rate are evaluated. The models including the shadow rate interaction term are found to outperform the benchmark ones according to both sets of criteria except in countries operating an official inflation targeting regime. The presence or absence of a zero lower bound affects which type of shadow rate produces more accurate inflation forecasts.