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

43 Pages Posted: 30 Aug 2018

See all articles by Thomas M. Mertens

Thomas M. Mertens

Federal Reserve Bank of San Francisco

John C. Williams

Federal Reserve Bank of New York

Date Written: August , 2018

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.

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.

Keywords: zero lower bound, inflation expectations, monetary policy, multiple equilibria

JEL Classification: E43, E52, G12

Suggested Citation

Mertens, Thomas M. and Williams, John C., What to Expect From the Lower Bound on Interest Rates: Evidence from Derivatives Prices (August , 2018). FRB of New York Staff Report No. 865. Available at SSRN: https://ssrn.com/abstract=3241390 or http://dx.doi.org/10.2139/ssrn.3241390

Thomas M. Mertens

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

John C. Williams (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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