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Effective lower bound risk

Timothy S. Hills, Taisuke Nakata and Sebastian Schmidt ()

European Economic Review, 2019, vol. 120, issue C

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% 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; Inflation targeting; Risky steady state; Tail risk; Effective lower bound (search for similar items in EconPapers)
JEL-codes: E32 E52 (search for similar items in EconPapers)
Date: 2019
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Persistent link: https://EconPapers.repec.org/RePEc:eee:eecrev:v:120:y:2019:i:c:s0014292119301813

DOI: 10.1016/j.euroecorev.2019.103321

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European Economic Review is currently edited by T.S. Eicher, A. Imrohoroglu, E. Leeper, J. Oechssler and M. Pesendorfer

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