Expectations and the neutrality of interest rates

BIS Working Papers  |  No 1136  | 
26 October 2023



What is the dynamic effect of interest rates on inflation, in our world of abundant reserves, in which central banks set nominal interest rates, do not control money supplies, do not make equilibrium-selection threats and cannot directly change fiscal policy? And how do interest rates then affect output, employment and other variables?


In 1972, Bob Lucas studied expectations and the neutrality – and temporary non-neutrality – of money. In our world, in which central banks set interest rates, there is an analogous theory of inflation under interest rate targets. The theory describes inflation that is stable and determinate under an interest rate peg, analogous to the monetarist analysis of a k% money growth rule. However, it is not settled whether and how the central bank can temporarily lower inflation by raising interest rates, without a change in fiscal policy. This paper is a synthetic essay, an evaluation of what we know and do not know about questions crucial to current policy.


We now have a theory of inflation under interest rate targets in which inflation is stable and determinate. However, stability under an interest rate peg and approximate long-run neutrality imply that higher nominal interest rates eventually produce higher inflation. In the short run, higher interest rates only lower inflation if they are accompanied by tighter fiscal policy in a range of models. It is hard to find a model in which higher nominal interest rates temporarily lower inflation, without a change in fiscal policy. I exhibit one such model but its effect is much weaker than what economists and central bankers currently believe.


Our central banks set interest rate targets, and do not even pretend to control money supplies. How do interest rates affect inflation? We finally have a complete theory of inflation under interest rate targets and unconstrained liquidity. Its long-run properties mirror those of monetary theory: Inflation can be stable and determinate under interest rate targets, including a peg, analogous to a k-percent rule. The zero bound era is confirmatory evidence. Uncomfortably, stability means that higher interest rates eventually raise inflation, just as higher money growth eventually raises inflation. Sticky prices generate some short-run nonneutrality as well: Higher nominal interest rates can raise real rates and lower output. A model in which higher nominal interest rates temporarily lower inflation, without a change in fiscal policy, is a harder task. I exhibit one such model, but it paints a much more limited picture than standard beliefs. We either need a model with a stronger effect, or to accept that higher interest rates have quite limited power to lower inflation. Empirical understanding of how interest rates affect inflation without fiscal help is also a wide-open question.

JEL classification: E4, E5

Keywords: interest rates, inflation, neutrality, non-neutrality

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