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June 2014 issue
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Coenen, Warne
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Risks to Price Stability, the Zero Lower Bound, and Forward Guidance: A Real-Time Assessment

by Günter Coenen and Anders Warne
European Central Bank

Abstract

This paper employs stochastic simulations of the New Area- Wide Model—a microfounded open-economy model developed at the ECB—to investigate the consequences of the zero lower bound on nominal interest rates for the evolution of risks to price stability in the euro area during the recent financial crisis. Using a formal measure of the balance of risks, which is derived from policymakers’ preferences about inflation outcomes, we first show that downside risks to price stability were considerably greater than upside risks during the first half of 2009, followed by a gradual rebalancing of these risks until mid-2011 and a renewed deterioration thereafter. We find that the lower bound has induced a noticeable downward bias in the risk balance throughout our evaluation period because of the implied amplification of deflation risks. We then illustrate that, with nominal interest rates close to zero, forward guidance in the form of a time-based conditional commitment to keep interest rates low for longer can be successful in mitigating downside risks to price stability. However, we find that the provision of time-based forward guidance may give rise to upside risks over the medium term if extended too far into the future. By contrast, time-based forward guidance complemented with a threshold condition concerning tolerable future inflation can provide insurance against the materialization of such upside risks.

JEL Codes: E31, E37, E52, E58.

 
Full article (PDF, 48 pages, 726 kb)

Discussion by Ragna Alstadheim