The likelihood of effective lower bound events

Summary

Focus

The paper estimates the probability that the economy will hit its effective lower bound for the nominal interest rate (ELB risk), ie the likelihood that the monetary authority will not be able to reduce its monetary policy rate to further ease monetary policy and must therefore consider unconventional measures. In addition, the paper provides estimates of the expected duration of such an event. The study focuses on eight advanced economies (Canada, the euro area, Japan, Norway, Sweden, Switzerland, the United Kingdom and the United States). It also examines the differences between the ELB risk estimates found in the literature.

Contribution

The paper provides ELB risk estimates that are based on a fully estimated empirical model. So far, most studies have drawn on calibrated models and assumptions about the steady-state values of macroeconomic variables. The approach in this paper makes use of data on recent actual ELB events in advanced countries. Furthermore, the paper contributes to the discussion on why some frameworks provide unrealistically high estimates of ELB risk. From the econometric point of view, the paper's contribution lies in combining recent econometric techniques and applying them to all considered countries simultaneously.

Findings

The paper provides estimates of the ELB risk for the short and medium run. It finds that the differences in ELB risk estimates between various frameworks stem from three factors:

1. whether the steady states (especially the interest rate steady state) are assumed or estimated;
2. whether the uncertainty of the steady state is a part of the estimation procedure; and
3. whether the model is non-linear.

Abstract

This paper provides estimates of the probability of an economy hitting its effective lower bound (ELB) on the nominal interest rate and of the expected duration of such an event for eight advanced economies. To that end, a mean-adjusted panel vector autoregression with static interdependencies and the possibility of regime change is estimated. The simulation procedure produces ELB risk estimates for both the short term, where the current phase of the business cycle plays an important role, and the medium term, where the occurrence of an ELB situation is determined mainly by the equilibrium values of macroeconomic variables. The paper also discusses the ELB event probability estimates with respect to previous approaches used in the literature.

JEL classification: E37, E52, C11

Keywords: effective lower bound, ELB risk, mean adjustment, panel VAR, regime change