Precautionary Pricing: The Disinflationary Effects of ELB Risk

Abstract

We construct a model to evaluate the role that the risk of future effective lower bound (ELB) episodes plays as a factor behind the persistently weak inflation witnessed in many advanced economies since the Great Recession. In our model, a range of precautionary channels cause ELB risk to affect inflation and other macroeconomic outcomes even during ?normal times? when nominal rates are far away from the ELB. This behavior is enhanced through a growth channel that captures possible long-lasting output declines at the ELB. We show that ELB risk substantially weighs on inflation even when the policy rate is above the ELB. Our model also predicts substantially below-target inflation expectations and negative inflation risk premia.