Finance and Economics Discussion Series: 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.