Forecast Uncertainty in the Neighborhood of the Effective Lower Bound: How Much Asymmetry Should We Expect?

Abstract

The lower bound on interest rates has restricted the impact of conventional monetary policies over recent years and could continue to do so in the near future, with the decline in natural real rates not predicted to reverse any time soon. A binding lower bound on interest rates has consequences not only for point forecasts but also for the entire model forecast distribution. In this paper we investigate the ramifications of the lower bound constraint on the forecast distributions from DSGE models and the implications for risk and uncertainty. To that end we start out by making the case for regime-switching as a framework for imposing the lower bound constraint on interest rates in DSGE models. We then use the framework to investigate the implications of the lower bound constraint on the forecast distributions and try to answer the question of how much asymmetry we should expect when the lower bound binds. The results suggest that: i) a lower bound constraint need not in itself imply asymmetric fan charts, ii) the degree of asymmetry of fan charts depends on various factors such as the degree of interest rate smoothing and the degree of price rigidity, and iii) different approaches to imposing the lower bound yield different results for both the width of the fan charts and their asymmetry.

Keywords: Effective Lower Bound, Regime-Switching, DSGE, Forecast Uncertainty, Fan Charts