Zero Lower Bound Risk and Long-Term Inflation in a Time Varying Economy

Using a Time Varying Parameters Vector Auto Regression framework, I construct an index, the Zero Probability Index (ZPI), based on the probability of the nominal interest rate hitting the zero lower bound (ZLB) within 10 quarters. I show how the probability of reaching the ZLB evolves over time and measure how a rise in the inflation target can reduce this probability. High ZPI episodes tend to occur during recessions and are c by a combination of the initial state of the variables and the estimated volatility of the shocks. However, not all episodes of a high ZPI share the same causes. In the US recessions of the 1980s, the probability was influenced significantly by an exceptionally volatile environment that overcame the dampening influence of the period’s high nominal interest rates. On the other hand, the high ZPI for the 2001 and 2007 recessions were mainly defined by an initial state of low interest rates. Because of this difference, an increase in the inflation target was much more effective in reducing the estimated probability of the interest rate reaching the ZLB in the latter episodes.