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Interest rates as options: assessing the markets' view of the liquidity trap

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Abstract

Nominal short term interest rates have been low in the United States, so low that some have wondered whether the federal funds rate is likely to hit its lower bound at 0 percent. Such a scenario, which some economists have called the liquidity trap, would imply that the Federal Reserve could no longer lower short-term interest rates to counter any deflationary tendencies in the economy. In this paper, I use an affine term structure model to infer what interest rates tell us about the probability, as assessed by financial market participants, of such an event taking place. I also examine whether U.S. short-term rates have been low enough to distort the shape of the yield curve.

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  • Antulio N. Bomfim, 2003. "Interest rates as options: assessing the markets' view of the liquidity trap," Finance and Economics Discussion Series 2003-45, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2003-45
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    1. Pierluigi Balduzzi & Sanjiv Ranjan Das & Silverio Foresi, 1998. "The Central Tendency: A Second Factor In Bond Yields," The Review of Economics and Statistics, MIT Press, vol. 80(1), pages 62-72, February.
    2. Harvey,Andrew C., 1991. "Forecasting, Structural Time Series Models and the Kalman Filter," Cambridge Books, Cambridge University Press, number 9780521405737.
    3. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    4. Babbs, Simon H. & Nowman, K. Ben, 1999. "Kalman Filtering of Generalized Vasicek Term Structure Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(1), pages 115-130, March.
    5. Black, Fischer, 1995. "Interest Rates as Options," Journal of Finance, American Finance Association, vol. 50(5), pages 1371-1376, December.
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    Cited by:

    1. Christensen, Jens H.E. & Lopez, Jose A. & Rudebusch, Glenn D., 2015. "A probability-based stress test of Federal Reserve assets and income," Journal of Monetary Economics, Elsevier, vol. 73(C), pages 26-43.
    2. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
    3. Krippner, Leo, 2013. "Measuring the stance of monetary policy in zero lower bound environments," Economics Letters, Elsevier, vol. 118(1), pages 135-138.
    4. Kortela, Tomi, 2016. "A shadow rate model with time-varying lower bound of interest rates," Bank of Finland Research Discussion Papers 19/2016, Bank of Finland.
    5. Lemke, Wolfgang & Vladu, Andreea L., 2016. "Below the zero lower bound: A shadow-rate term structure model for the euro area," Discussion Papers 32/2016, Deutsche Bundesbank.
    6. Naohiko Baba, 2006. "Financial Market Functioning and Monetary Policy: Japan's Experience," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 24(S1), pages 39-71, December.
    7. Kortela, Tomi, 2016. "A shadow rate model with time-varying lower bound of interest rates," Research Discussion Papers 19/2016, Bank of Finland.
    8. Junttila, Juha & Perttunen, Jukka & Raatikainen, Juhani, 2021. "Keep the faith in banking: New evidence for the effects of negative interest rates based on the case of Finnish cooperative banks," International Review of Financial Analysis, Elsevier, vol. 75(C).
    9. Don H. Kim, 2008. "Zero bound, option-implied PDFs, and term structure models," Finance and Economics Discussion Series 2008-31, Board of Governors of the Federal Reserve System (U.S.).
    10. repec:zbw:bofrdp:2016_019 is not listed on IDEAS

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    Keywords

    Interest rates; Federal funds rate;

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