1. Deflation and the Zero Interest Bound Federal Reserve Bank of Minneapolis November 25, 2003 Robert E. Lucas, Jr.

2. P OLICY PROBLEM _________________________ Take as given (for sake of discussion) (1)that task of monetary policy is “inflation targeting”: maintenance of low, steady inflation rate; (2)that success requires continuous readjustment—can’t set the controls and shut down the Fed.

3. T WO APPROACHES _________________________ (1)When inflation rate is above target, raise interest rate; when inflation is below... (2)When inflation rate is above target, reduce money growth;…. Interest control vs. money supply control

4. P ROBLEM OF D EFLATION ___________________ (in public discussion) is a problem only for people who think of policy exclusively in terms of interest rate control. “What if we find ourselves in a situation with inflation below target (e.g. deflation) and near zero interest rates? There is nothing we can do. We’re stuck!”

5. S O WHAT ? ______________________ Is deflation such a bad place to be stuck? Fair question: Key issue in choice of target. But once target is selected, must face question of what to do when inflation is off target. Important that policy rules generate action that is (1) feasible and (2) moves inflation closer to target, no matter what the state.

6. S O WHAT (CONTINUED) ? ___________ Won’t do to set 2% as target and then if -2% occurs say “Oh, -2% is fine too. Let’s stay here instead.” No policy at all. If targeting is serious, and if interest rate setting is means to attain it, then zero bound on interest is important. Implies that central bank can be helpless to do job.

7. M ONEY SUPPLY CONTROL_____________ With money supply control, dilemmas of deflation and near zero interest rates disappear. Inflation below target? Raise money growth, inflation rises, interest rates follow. How achieve this? Open market operations at zero interest? Ask someone from the Bank of Brazil.

8. E VIDENCE___________________________ But isn’t there solid evidence that interest rate control has been key to success in last 20 years of U.S. monetary policy? Isn’t it well known that money supply growth is not reliably related to inflation? Short answers are NO and NO. Look at - cross-section of economies - U.S. time series

10. I NTERPRETATION______________________ Stable real rate plus inflation premium, a la Irving Fisher? Central Bank policy response to inflation? My view? 100% Fisher Believe figure contains no information on central bank interest rate policy rules.

11. Interest and Inflation Rates, U.S. 1948- 2000

12. I NTERPRETATION______________________ Same picture as cross section (though time series harder to interpret) My view? 98% Fisher Believe figure contains no information on central bank interest rate policy rules. Taylor rule? Maybe. Or just misinterpretation of behavior that Fisher has already explained.

13. ….BUT WHAT IF…_____________________ …high interest rates did reflect, in part, Fed anti- inflation policies? Did these policies in fact influence consumer and business behavior? More slippage here.

14. Various Monthly Yields: Low frequency only

15. C ONCLUDE__________________________ Easy to see and understand effects of inflation on short term interest rates, in U.S. and elsewhere. Hard to see (or imagine) any causal connection from money market rates to spending flows and inflation rates.

16. C AN MONEY CONTROL DO ANY BETTER? Multiplicity of monetary aggregates… Changes in financial technology… Instability of velocity… Many good excuses for not looking at money data, but let’s do it anyway.

18. U NSTABLE VELOCITY?_________________ From 1948 to 1976, velocity rose from 1.5 to 2.5 Suppose money growth had been set and locked in 1948 to attain a 2% inflation rate, assuming constant velocity of 1.5. Then actual inflation would have averaged 3.8% Big mistake? I think so, but maybe no larger than the mistake we actually made …..and no need to be locked in!

19. W HAT IS AT STAKE?__________________ U.S. inflation record has been fine under interest rate policy. Why complain? Aren’t “raise interest” and “reduce money growth” just two ways of saying the same thing? No, they are not. Discussing monetary policy entirely in terms of interest rates leads us to describe situations of very low interest rates as situations where the central bank is helpless to raise inflation rate...

20. W HAT IS AT STAKE?__________________ …when in fact they are not helpless at all. Think of the U.S. Federal Reserve in the 1930s, and Japan in the 1990s. What we say matters, not just what we do. Bad economics leads to bad public debates, bad decisions, bad outcomes.

21. W E CAN DO BETTER__________________ ECB is discussing monetary aggregates and interest rates in a way that I like. See Otmar Issing, et al., Monetary Policy in the Euro Area: Strategy and Decision Making at the ECB. Good discussion of practical aspects of monetary policy…and no worries at all about deflation and the zero bound problem.