Another source of “drag” has been at work.3 Identifying those drag factors is important when accounting for disinflationary trends in the past, but also when assessing whether these trends will persistent in the future. The drag If you consider the traditional determinants of inflation, there are at least three plausible sources of disinflationary “drag”: slack in the economy, a weaker relationship between slack and wages and lower levels of inflation expectations. These explanations are not mutually exclusive. Higher levels of slack, or a weaker relationship between slack and wages, could lower inflation expectations – for example, if demand is weak today, people may expect lower inflation tomorrow. And lower wage and inflation expectations could themselves depress demand – for example, by raising levels of real interest rates. Nonetheless, it is worth considering these explanations in turn. (a)  Slack and the Phillips Curve  The short-term relationship between unemployment or the output gap and wage growth or inflation – the Phillips curve – is one of the most intensively studied in macro-economics.4 Despite that, empirical estimates of the Phillips curve have tended to be poorly-identified. That may reflect the effects of structural and behavioural shifts, which have the potential to alter historically-estimated Phillips curve relationships. For example, changes in the credibility of the monetary policy regime can cause inflation and wage expectations to alter, causing the Phillips curve to shift around over time for a given level of slack.
Chart 30: Simulation of Bank rate and CPI inflation, if the starting level of slack is 2% Path for Bank rate  Per cent 1.5  Per cent 3  CPI inflation  2.5 1 2 1.5  0.5  1 0 0.5 2013  2014  2015  2016  2017  -0.5 2013 2018  February IR Simulation with a lower bound at 0% Simulation with a lower bound at 0.5%  2014  2015  2016  2017  0 2018  February IR Simulation with a lower bound at 0% Simulation with a lower bound at 0.5%  Source: ONS and Bank Calculations. Simulations show optimal policy under full commitment. Of course, there are good reasons why monetary policy is not set by algorithm. These simulations ignore a number of important practical uncertainties. For example, they assume that this policy path is fully credible and effective in stimulating demand and inflation expectations. In practice, the effects of a policy easing cannot be known with certainty and 18  BIS central bankers’ speeches  policy credibility cannot be guaranteed. Moreover, there are upside as well as downside risks to the inflation outlook. Nonetheless, these experiments are in my view the right baseline when assessing the appropriate policy stance today. Conclusion Inflation has dropped like a stone over the past year, to close to zero. This largely, but not wholly, reflects external forces.