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The Risky Steady State and the Interest Rate Lower Bound

Author

Listed:
  • Taisuke Nakata

    (Federal Reserve Board)

  • Sebastian Schmidt

    (European Central Bank)

  • Timothy Hills

    (New York University)

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 45 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 recent ELB experience has led households and firms to revise up their estimate of the ELB frequency.

Suggested Citation

  • Taisuke Nakata & Sebastian Schmidt & Timothy Hills, 2016. "The Risky Steady State and the Interest Rate Lower Bound," 2016 Meeting Papers 39, Society for Economic Dynamics.
  • Handle: RePEc:red:sed016:39
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    References listed on IDEAS

    as
    1. Fernández-Villaverde, Jesús & Gordon, Grey & Guerrón-Quintana, Pablo & Rubio-Ramírez, Juan F., 2015. "Nonlinear adventures at the zero lower bound," Journal of Economic Dynamics and Control, Elsevier, vol. 57(C), pages 182-204.
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    4. Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2012. "The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?," Review of Economic Studies, Oxford University Press, vol. 79(4), pages 1371-1406.
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    9. Taisuke Nakata, 2017. "Uncertainty at the Zero Lower Bound," American Economic Journal: Macroeconomics, American Economic Association, vol. 9(3), pages 186-221, July.
    10. Sebastian Schmidt, 2013. "Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(7), pages 1335-1350, October.
    11. Gavin, William T. & Keen, Benjamin D. & Richter, Alexander & Throckmorton, Nathaniel, 2013. "The stimulative effect of forward guidance," Working Papers 2013-38, Federal Reserve Bank of St. Louis, revised 30 Apr 2014.
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    15. Olivier Coibion & Yuriy Gorodnichenko & Johannes Wieland, 2012. "The Optimal Inflation Rate in New Keynesian Models: Should Central Banks Raise Their Inflation Targets in Light of the Zero Lower Bound?," Review of Economic Studies, Oxford University Press, vol. 79(4), pages 1371-1406.
    16. Gust, Christopher J. & Lopez-Salido, J. David & Smith, Matthew E. & Herbst, Edward, 2012. "The Empirical Implications of the Interest-Rate Lower Bound," Finance and Economics Discussion Series 2012-83, Board of Governors of the Federal Reserve System (U.S.), revised Jan 2016.
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    Citations

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    Cited by:

    1. 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.
    2. repec:ecb:ecbrbu:2018:0045:1 is not listed on IDEAS
    3. Philippe Andrade & Jordi Galí & Hervé Le Bihan & Julien Matheron, 2017. "The optimal inflation target and the natural rate of interest," Economics Working Papers 1591, Department of Economics and Business, Universitat Pompeu Fabra.
    4. Seneca, Martin, 2016. "Risk shocks close to the zero lower bound," Bank of England working papers 606, Bank of England.
    5. Arias, Jonas E. & Erceg, Christopher & Trabandt, Mathias, 2016. "The macroeconomic risks of undesirably low inflation," European Economic Review, Elsevier, vol. 88(C), pages 88-107.
    6. Nakata, Taisuke, 2016. "Optimal fiscal and monetary policy with occasionally binding zero bound constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 73(C), pages 220-240.
    7. repec:ecb:ecbrbu:2018:0045: is not listed on IDEAS
    8. Vadym Lepetyuk & Lilia Maliar & Serguei Maliar, 2017. "Should Central Banks Worry About Nonlinearities of their Large-Scale Macroeconomic Models?," Staff Working Papers 17-21, Bank of Canada.
    9. Koji Takahashi, 2016. "TIPS: The Trend Inflation Projection System and Estimation Results," Bank of Japan Working Paper Series 16-E-18, Bank of Japan.
    10. Hirokuni Iiboshi & Mototsugu Shintani & Kozo Ueda, 2018. "Estimating a Nonlinear New Keynesian Model with a Zero Lower Bound for Japan," Working Papers e120, Tokyo Center for Economic Research.
    11. Taisuke Nakata & Sebastian Schmidt, . "Gradualism and Liquidity Traps," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    12. Narayana R. Kocherlakota, 2016. "Sluggish Inflation Expectations: A Markov Chain Analysis," NBER Working Papers 22009, National Bureau of Economic Research, Inc.
    13. Sebastian Schmidt, 2016. "The effective lower bound: some implications for inflation dynamics beyond the current low interest rate environment," Research Bulletin, European Central Bank, vol. 29.
    14. repec:ecb:ecbrbu:2016:0029:1 is not listed on IDEAS
    15. Lansing, Kevin J., 2017. "Endogenous Regime Switching Near the Zero Lower Bound," Working Paper Series 2017-24, Federal Reserve Bank of San Francisco.
    16. Timothy S. Hills & Taisuke Nakata & Sebastian Schmidt, 2016. "The Risk of Returning to the Effective Lower Bound : An Implication for Inflation Dynamics After Lift-Off," FEDS Notes 2016-02-12-2, Board of Governors of the Federal Reserve System (U.S.).
    17. Taisuke Nakata, 2017. "Uncertainty at the Zero Lower Bound," American Economic Journal: Macroeconomics, American Economic Association, vol. 9(3), pages 186-221, July.
    18. Kenny, Geoff & Dovern, Jonas, 2017. "The long-term distribution of expected inflation in the euro area: what has changed since the great recession?," Working Paper Series 1999, European Central Bank.

    More about this item

    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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