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What to expect from the lower bound on interest rates: evidence from derivatives prices

Author

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  • Mertens, Thomas M.

    (Federal Reserve Bank of San Francisco)

  • Williams, John C.

    (Federal Reserve Bank of New York)

Abstract

This paper analyzes the effects of the lower bound for interest rates on the distributions of expectations for future inflation and interest rates. We study a stylized New Keynesian model 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 the 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

  • Mertens, Thomas M. & Williams, John C., 2018. "What to expect from the lower bound on interest rates: evidence from derivatives prices," Staff Reports 865, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:865
    Note: This is an updated version of a working paper originally issued by the Federal Reserve Bank of San Francisco (Working Paper 2018-03) in January 2018.
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    References listed on IDEAS

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    1. Schmidt, Sebastian & Nakata, Taisuke & Hills, Timothy, 2016. "The risky steady state and the interest rate lower bound," Working Paper Series 1913, European Central Bank.
    2. Crump, Richard K. & Eusepi, Stefano & Moench, Emanuel, 2016. "The term structure of expectations and bond yields," Staff Reports 775, Federal Reserve Bank of New York, revised 01 Apr 2018.
    3. 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.
    4. 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.
    5. 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.
    6. 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. Mertens, Thomas M. & Williams, John C., 2019. "Monetary Policy Frameworks and the Effective Lower Bound on Interest Rates," Working Paper Series 2019-1, Federal Reserve Bank of San Francisco.

    More about this item

    Keywords

    zero lower bound; inflation expectations; monetary policy; multiple equilibria;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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