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What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices


  • Thomas M. Mertens
  • John C. Williams


This paper analyzes the effects of the lower bound for interest rates on the distributions of expectations for future inflation and interest rates. We use a stylized model economy where the policy instrument is subject to a lower bound to motivate the empirical analysis. Two equilibria emerge: In the ?target equilibrium,? policy is unconstrained most or all of the time, whereas in the ?liquidity trap equilibrium,? policy is mostly or always constrained. We use options data on future interest rates and inflation to study whether the decrease in the natural rate of interest leads to forecast densities consistent with the theoretical model. We develop a lower bound indicator that captures the effects of the lower bound on the distribution of interest rates. Qualitatively, we find that evidence is largely consistent with the theoretical predictions in the target equilibrium and find no evidence in favor of the liquidity trap equilibrium. Quantitatively, while the lower bound has a sizable effect on the distribution of future interest rates, its impact on forecast densities for inflation is relatively modest.

Suggested Citation

  • Thomas M. Mertens & John C. Williams, 2018. "What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices," Working Paper Series 2018-3, Federal Reserve Bank of San Francisco, revised 18 Jan 2018.
  • Handle: RePEc:fip:fedfwp:2018-03
    DOI: 10.24148/wp2018-03

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    References listed on IDEAS

    1. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
    2. Timothy S. Hills & Taisuke Nakata & Sebastian Schmidt, 2016. "The Risky Steady State and the Interest Rate Lower Bound," Finance and Economics Discussion Series 2016-9, Board of Governors of the Federal Reserve System (U.S.).
    3. Michael T. Kiley & John M. Roberts, 2017. "Monetary Policy in a Low Interest Rate World," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 48(1 (Spring), pages 317-396.
    4. Michael T. Kiley, 2020. "What Can the Data Tell Us about the Equilibrium Real Interest Rate?," International Journal of Central Banking, International Journal of Central Banking, vol. 16(3), pages 181-209, June.
    5. Richard K. Crump & Stefano Eusepi & Emanuel Moench, 2016. "The term structure of expectations and bond yields," Staff Reports 775, Federal Reserve Bank of New York, revised 01 Feb 2017.
    6. Gurkaynak, Refet S. & Sack, Brian & Wright, Jonathan H., 2007. "The U.S. Treasury yield curve: 1961 to the present," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2291-2304, November.
    7. Marco Del Negro & Domenico Giannone & Marc P. Giannoni & Andrea Tambalotti, 2017. "Safety, Liquidity, and the Natural Rate of Interest," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 48(1 (Spring), pages 235-316.
    8. James D. Hamilton & Ethan S. Harris & Jan Hatzius & Kenneth D. West, 2016. "The Equilibrium Real Funds Rate: Past, Present, and Future," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 660-707, November.
    9. Mendes, Rhys R., 2011. "Uncertainty and the Zero Lower Bound: A Theoretical Analysis," MPRA Paper 59218, University Library of Munich, Germany.
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    Cited by:

    1. Aeimit Lakdawala & Michael Bauer & Philippe Mueller, 2019. "Market-Based Monetary Policy Uncertainty," 2019 Meeting Papers 1403, Society for Economic Dynamics.
    2. Pablo Cuba-Borda & Sanjay R. Singh, 2019. "Understanding Persistent Stagnation," International Finance Discussion Papers 1243, Board of Governors of the Federal Reserve System (U.S.).
    3. Lamla, Michael & PJaifar, Damian & Rendell, Lea, 2019. "Inflation and Deflationary Biases in Inflation Expectations," Essex Finance Centre Working Papers 24771, University of Essex, Essex Business School.
    4. Thomas M. Mertens & John C. Williams, 2019. "Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates," AEA Papers and Proceedings, American Economic Association, vol. 109, pages 427-432, May.
    5. Thomas M. Mertens & John C. Williams, 2019. "Tying Down the Anchor: Monetary Policy Rules and the Lower Bound on Interest Rates," Working Paper Series 2019-14, Federal Reserve Bank of San Francisco, revised 01 May 2019.
    6. Hills, Timothy S. & Nakata, Taisuke & Schmidt, Sebastian, 2019. "Effective lower bound risk," European Economic Review, Elsevier, vol. 120(C).

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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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