“Interest Rates as Options”: Assessing the Markets’ View of the Liquidity Trap

Nominal short term interest rates have been low in the United States, so low that some have wondered whether the federal funds rate is likely to hit its lower bound at 0 percent. Such a scenario, which some economists have called the liquidity trap, would imply that the Federal Reserve could no longer lower short-term interest rates to counter any deflationary tendencies in the economy. In this paper, I use an affine term structure model to infer what interest rates tell us about the probability, as assessed by financial market participants, of such an event taking place. I also examine whether U.S. short-term rates have been low enough to distort the shape of the yield curve.

Introduction
Nominal short-term interest rates have been low in the United States, and, with inflation also running at very low levels, many readings on real short-term rates have actually drifted below zero. Nominal rates have been so low that some market observers have wondered about the possibility that the federal funds rate|the key interest rate controlled by the Federal Reserve|may reach its lower bound at 0 percent. Such a scenario would be reminiscent of what economists as far back as Keynes (1936) have called a liquidity trap, a situation where the Federal Reserve would no longer be able to lower short-term interest rates to react to an eventual pick-up in deflationary forces.

Author: Antulio N. Bomfim

Source: Lancaster University Management School

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