That reflects both lower inflation expectations and smaller risk premia to compensate for future inflation uncertainty. The total inflation premium - the sum of expected inflation and the inflation risk premium - is measured by the difference between yields on conventional and index-linked government securities. Chart 2 shows that the total inflation premium fell significantly on the announcement of Bank of England independence and the creation of the MPC. It is highly suggestive of a fall not just in expected inflation but also in the inflation risk premium. In principle, the behaviour of businesses and households depends on real interest rates - nominal interest rates less 2 the expected increase in prices. To the extent that the inflation risk premium falls, then so too does the level of real interest rates. The evidence in Chart 2 suggests that real rates have fallen too, although by less than nominal rates. Chart 1 Annual inflation in the UK  Note: Four-quarter growth rate of the quarterly retail price index (RPI) until 1974, and four-quarter growth rate of the quarterly retail price index excluding mortgage interest payments (RPIX) after 1974. Note that the RPI methodology before 1974 did not include mortgage interest payments, so the RPI series before 1974 is equivalent to RPIX in that sense. Data up to 2002 Q3. Source: ONS. 1  The conclusion reflects statistical tests including first-order auto correlations of consumer price inflation over ten-year rolling windows, and estimated spectral densities for inflation from a random coefficient AR (4) and GARCH (1,1) model.
Excess domestic demand combined with low productivity growth should be reflected in rising prices, and domestic measures of price and wage inflation in the catchingup economies were indeed running considerably higher than the euro area average on a cumulative basis. Average annual inflation differentials in the 2002 to 2008 period were in the range of 0.5 to 1.5 percentage points. However, these developments were not considered especially alarming by some observers as they were interpreted as reinforcing the theory of Balassa-Samuelson equalisation. Some also saw inflation differentials as being more reflective of low inflation in Germany as it went through a phase of wage adjustment. Overall, this may have led to less concern about the lack of real convergence in productivity levels than was warranted. 8  European Commission, “EMU@10: Successes and challenges after ten years of Economic and Monetary Union”, European Economy 2, 2008. 9  See for example Minsky, H (1982), “Can ‘it’ happen again?”, Essays on Instability and Finance. 10  Drehmann et al (2012), “Characterising the financial cycle: don’t lose sight of the medium term!”, BIS Working Papers No 380, June 2012. 11  For a detailed explanation see Borio et al (2013), “Rethinking potential output: Embedding information about the financial cycle”, BIS Working Papers No 404, February 2013. 4  BIS central bankers’ speeches  Achieving sustainable convergence It was only when the financial cycle turned that the unsustainability of economic convergence became apparent.