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

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Staff Reports

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

Number 865
August 2018 Revised September 2020

JEL classification: E52

Authors: Thomas M. Mertens and John C. Williams

This paper analyzes the effects of the lower bound for interest rates on the distributions of 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 real rate of interest leads to forecast densities consistent with the theoretical model. Qualitatively, we find that the evidence is 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. We develop a lower bound indicator that captures the effects of the lower bound on the distribution of interest rates.

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.

Available only in PDF

Author Disclosure Statement(s)

Thomas M. Mertens
I declare that I have no relevant or material financial interests that relate to the research described in this paper.

John C. Williams
The author declares that he has no relevant or material financial interests that relate to the research described in this paper, "What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices."

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