Abstract:
Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems.

This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising.

We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models.

In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve's asset purchases have been effective at mitigating the economic costs of the ZLB.

In particular, model simulations indicate that the past and projected expansion of the Federal Reserve's securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1-1/2 percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.

Read Full: Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?

PDF format, 568KB, 58Pages.

Hess Chung
Federal Reserve Board of Governors
Jean-Philippe Laforte
Federal Reserve Board of Governors
David Reifschneider
Federal Reserve Board of Governors
John C. Williams
Federal Reserve Bank of San Francisco

FEDERAL RESERVE BANK OF SAN FRANCISCO
WORKING PAPER SERIES

Introduction
The zero lower bound (ZLB) on nominal interest rates limits the ability of central banks to add monetary stimulus to offset adverse shocks to the real economy and to check unwelcome disinflation. The experience of Japan in the 1990s motivated a great deal of research on both the macroeconomic consequences of the ZLB and on monetary policy strategies to overcome these effects.

Economic theory has provided important insights about both the dynamics of the economy in the vicinity of the ZLB and possible policy strategies for mitigating its effects. But theory alone cannot provide a quantitative assessment of the practical importance of the ZLB threat, which depends critically on the frequency and degree to which the lower bound constrains the actions of the central bank as it seeks to stabilize real activity and inflation, thereby impinging on the unconstrained variability and overall distribution of the nominal funds rate that would otherwise arise.

These factors in turn depend on the expected magnitude and persistence of adverse shocks to the economy; the dynamic behavior of real activity, inflation, and expectations; and the monetary policy strategy followed by the central bank, including its inflation target. (The latter factor plays a key role in ZLB dynamics, because the mean of the unconstrained distribution of the nominal funds rate equals the inflation target plus the economy’s equilibrium real short-term rate of interest.) The quantitative evaluation of these factors requires one to use a model of the economy with sound empirical foundations.

Previous research was generally sanguine about the practical risks posed by the ZLB, as long as the central bank did not target too low an inflation rate. Reifschneider and Williams (2000) used stochastic simulations of the Federal Reserve’s large-scale rational-expectations macroeconometric model, FRB/US, to evaluate the frequency and duration of episodes when policy was constrained by the ZLB. ...

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