Shadow Federal Funds Rate
The Shadow Federal Funds Rate is an estimated policy rate constructed by economists to capture the effective stance of monetary policy when the Federal Reserve's conventional policy tool — the federal funds rate — is constrained at or near zero and unconventional measures such as quantitative easing are in use.
The federal funds rate — the overnight borrowing rate between banks that serves as the Federal Reserve's primary monetary policy instrument — has a practical lower bound near zero. When the Fed reduces rates to the zero lower bound (ZLB), as it did following the 2008 Global Financial Crisis and again in March 2020, its conventional policy tool loses effectiveness. The Fed cannot set nominal interest rates meaningfully below zero in ordinary circumstances, yet economic conditions may still call for additional monetary accommodation.
In response, the Fed has historically deployed unconventional policy tools: large-scale asset purchases (quantitative easing, or QE), forward guidance about the future path of interest rates, and yield curve control measures. These unconventional tools affect longer-term interest rates and financial conditions beyond the overnight rate, but their overall monetary policy impact is not directly comparable to a fed funds rate change.
The Shadow Federal Funds Rate was developed by economists including Leo Krippner of the Reserve Bank of New Zealand and Jing Cynthia Wu and Fan Dora Xia, whose widely cited Wu-Xia Shadow Rate model constructs an estimated policy rate that is unconstrained by the zero lower bound. When the Fed is engaged in QE, the shadow rate can fall significantly below zero — in effect, capturing how much additional accommodation the unconventional policies represent in fed-funds-rate-equivalent terms. When the shadow rate is deeply negative, it historically has indicated very accommodative monetary policy conditions. When the shadow rate rises — either because the Fed raises the actual fed funds rate or winds down QE — it historically indicated tightening monetary conditions.
From 2009 through 2015, the Wu-Xia Shadow Rate estimated the effective U.S. monetary policy stance as substantially more negative than zero — at times estimated below -3% — reflecting the considerable additional accommodation provided by multiple rounds of quantitative easing. After the Fed began raising rates in December 2015, the shadow rate converged with the actual fed funds rate.
The shadow rate concept becomes relevant again during periods of unconventional monetary policy. It provides macroeconomic researchers and policy analysts with a continuous time series of monetary policy stance that does not exhibit the artificial flatness at zero that the nominal federal funds rate shows during ZLB episodes, enabling more accurate modeling of monetary policy's historical effects on economic activity, inflation, and asset prices.
For equity and macro analysts, the Shadow Federal Funds Rate offers context for understanding how dramatically accommodative policy was during the post-2008 and post-2020 periods — context that the nominal near-zero rate alone understates, and that helps explain the powerful asset price inflation observed during those eras of extraordinary monetary accommodation.