Deflation and the Zero Interest Bound

Federal Reserve Bank of Minneapolis

November 25, 2003

Robert E. Lucas, Jr.

POLICY 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.

TWO 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

PROBLEM OF DEFLATION___________________

(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!”

SO 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.

SO 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.

MONEY 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.

EVIDENCE___________________________

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

INTERPRETATION______________________

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.

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

-2

0

2

4

6

8

10

12

14

16

1948

1950

1952

1954

1956

1958

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

Per

cen

tag

e

3-Month Treasury Bill Rate CPI 1yr inflation rate + 2%

Source: Samuel Reynard Swiss National Bank

INTERPRETATION______________________

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.

….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.

Various Monthly Yields: Low frequency only

CONCLUDE__________________________

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.

CAN 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.

-6

-1

4

9

14

19

48

19

50

19

52

19

54

19

56

19

58

19

60

19

62

19

64

19

66

19

68

19

70

19

72

19

74

19

76

19

78

19

80

19

82

19

84

19

86

19

88

19

90

19

92

19

94

19

96

19

98Op

po

rtu

nit

y C

os

t (P

erc

en

t)

1.5

2

2.5

3

3.5

4

4.5

Ve

loc

ity

3-Month Treasury Bill Rate MA Opportunity Cost MA Velocity

Source: Samuel Reynard Swiss National Bank

UNSTABLE 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!

WHAT 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...

WHAT 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.

WE 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.