THE ZERO LOWER BOUND: New evidence of its impact on uncertainty and economic activity

It is well known that the zero lower bound (ZLB) on the short-term nominal interest rate can have undesirable effects on the economy. New research by Michael Plante, Alexander Richter and Nathaniel Throckmorton shows it can also lead to greater uncertainty about the future economy, as well as a much stronger relationship between uncertainty and economic activity.

Their study, which is forthcoming in the Economic Journal, compares the periods before and after December 2008, when the US Federal Reserve took unprecedented action to lower the federal funds rate to its ZLB. As a result of that action, the Fed lost its ability to respond to negative economic events with its traditional policy tool.

The researchers find the correlation between uncertainty and economic activity was two to three times stronger when the Fed was constrained by the ZLB than before the Great Recession. Lags of real GDP growth were also more tightly linked with current uncertainty, indicating that poor economic conditions drive uncertainty.

Until now, economic research has focused most of its attention on how uncertainty affects economic activity, with uncertainty often viewed as exogenous. In this new work, causation runs in the opposite direction: the state of the economy caused the ZLB to bind, which increased uncertainty about the future economy.

To develop their analysis, the researchers work with a theoretical model that is often used to consider issues related to monetary policy and the ZLB. This model mathematically describes how households make decisions about how much to consume and save, how firms set prices and how the central bank (the Fed in the case of the United States) sets its policy rate.

The authors use a statistical procedure to estimate the model and ensure that it provides an adequate framework for thinking about the quantitative importance of the ZLB over time. This procedure also allows them to generate a model-based, data-driven measure of macroeconomic uncertainty.

An important finding from the model is that uncertainty rises when the policy rate comes close to or hits its ZLB. Why does this happen? The ZLB prevents the Fed from responding to unexpected negative economic events in its usual manner, and, as a result, those events affect the economy more severely than is usually the case. Uncertainty rises because people have greater difficulty predicting future economic outcomes.

The model also implies there is a much stronger connection between uncertainty and economic activity when the policy rate is at the ZLB. The researchers find strong evidence of this result in several popular measures of uncertainty: expected stock market volatility; forecast dispersion; and a recently developed index that accounts for several types of macroeconomic uncertainty (see Table 1 below).

The authors comment:

”The key takeaway from our work is that periods of high uncertainty do not necessarily mean uncertainty is exerting a large effect on the economy.”

”Sometimes changes in uncertainty are a by-product of what is happening in the economy. At other times, it stems from unique events not directly linked to economic activity.”

”Future research is aimed at quantifying the relative importance of these two effects.”

”The Zero Lower Bound and Endogenous Uncertainty” by Michael Plante, Alexander W Richter and Nathaniel A Throckmorton is forthcoming in the Economic Journal. Michael Plante and Alexander Richter are at the Federal Reserve Bank of Dallas. Nathaniel Throckmorton is at the College of William and Mary.

Michael Plante

Federal Reserve Bank of Dallas | +1(214) 922-5179 | michael.plante@dal.frb.org

Alexander Richter

Federal Reserve Bank of Dallas | +1(214) 922-5360 | alex.richter@dal.frb.org

Nathaniel Throckmorton

+1(757) 221-1318 | nathrockmorton@wm.edu