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Effective Lower Bound Risk

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  • Timothy S. Hills
  • Taisuke Nakata
  • Sebastian Schmidt

Abstract

Even when the policy rate is currently not constrained by its effective lower bound (ELB), the possibility that the policy rate will become constrained in the future lowers today's inflation by creating tail risk in future inflation and thus reducing expected inflation. In an empirically rich model calibrated to match key features of the U.S. economy, we find that the tail risk induced by the ELB causes inflation to undershoot the target rate of 2 percent by as much as 50 basis points at the economy's risky steady state. Our model suggests that achieving the inflation target may be more difficult now than before the Great Recession, if the likely decline in long-run neutral rates has led households and firms to revise up their estimate of the frequency of future ELB events.

Suggested Citation

  • Timothy S. Hills & Taisuke Nakata & Sebastian Schmidt, 2019. "Effective Lower Bound Risk," Finance and Economics Discussion Series 2019-077, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2019-77
    DOI: 10.17016/FEDS.2019.077
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    File URL: https://www.federalreserve.gov/econres/feds/files/2019077pap.pdf
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    Cited by:

    1. Budianto, Flora & Nakata, Taisuke & Schmidt, Sebastian, 2020. "Average Inflation Targeting and the Interest Rate Lower Bound," CEPR Discussion Papers 14400, C.E.P.R. Discussion Papers.

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    Keywords

    Deflationary Bias; Disinflation; Effective Lower Bound; Inflation Targeting; Risky Steady State; Tail Risk;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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