Risks to Price Stability, the Zero Lower Bound and Forward Guidance: A Real-Time Assessment

47 Pages Posted: 12 Sep 2013

See all articles by Günter Coenen

Günter Coenen

European Central Bank (ECB)

Anders Warne

European Central Bank (ECB)

Date Written: August 2013

Abstract

This paper employs stochastic simulations of the New Area-Wide Model -- a micro-founded 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 policy-makers’ 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 re-balancing 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.

Keywords: monetary policy, deflation, zero lower bound, forward guidance, DSGE modeling, Euro area

JEL Classification: E31, E37, E52, E58

Suggested Citation

Coenen, Günter and Warne, Anders, Risks to Price Stability, the Zero Lower Bound and Forward Guidance: A Real-Time Assessment (August 2013). ECB Working Paper No. 1582, Available at SSRN: https://ssrn.com/abstract=2311263 or http://dx.doi.org/10.2139/ssrn.2311263

Günter Coenen (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 7887 (Phone)
+49 69 1344 6575 (Fax)

Anders Warne

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
148
Abstract Views
902
Rank
356,899
PlumX Metrics