Expectations and the Neutrality of Interest Rates

51 years ago, Bob Lucas (1972a) published his pathbreaking analysis of the temporary non-neutrality of money. But our central banks set interest rate targets, and do not even pretend to control money supplies. How do interest rates affect inflation? Until recently, we have not had a complete theory of inflation under interest rate targets. Now we have such a theory. It mirrors the long-run properties 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 non-neutrality 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.