Effective Lower Bound Risk

63 Pages Posted: 27 Nov 2019

See all articles by Timothy Hills

Timothy Hills

New York University (NYU)

Taisuke Nakata

Board of Governors of the Federal Reserve System

Sebastian Schmidt

European Central Bank (ECB)

Date Written: 2019-11-04

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.

Keywords: Deflationary Bias, Disinflation, Effective Lower Bound, Inflation Targeting, Risky Steady State, Tail Risk

JEL Classification: E32, E52

Suggested Citation

Hills, Timothy and Nakata, Taisuke and Schmidt, Sebastian, Effective Lower Bound Risk (2019-11-04). FEDS Working Paper No. 2019-077. Available at SSRN: https://ssrn.com/abstract=3494183 or http://dx.doi.org/10.17016/FEDS.2019.077

Timothy Hills (Contact Author)

New York University (NYU) ( email )

Bobst Library, E-resource Acquisitions
20 Cooper Square 3rd Floor
New York, NY 10003-711
United States

Taisuke Nakata

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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