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

2018-03 | September 1, 2020

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.

Article Citation

Williams, John C., and Thomas M. Mertens. 2018. “What to Expect from the Lower Bound on Interest Rates: Evidence from Derivatives Prices,” Federal Reserve Bank of San Francisco Working Paper 2018-03. Available at https://doi.org/10.24148/wp2018-03

About the Authors
Thomas Mertens
Thomas Mertens is a vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Thomas Mertens
John C. Williams served as President and Chief Executive Officer of the Federal Reserve Bank of San Francisco from March 1, 2011 to June 17, 2018. Dr. Williams was previously the executive vice president and director of research for the San Francisco bank, which he joined in 2002. He began his career in 1994 as an […] Learn more about John C. Williams