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.
Such effects can be amplified if spending - consumption or investment - depends on the value of the assets that are used as collateral for loans. A fall in prices can produce a vicious circle in which the initial fall in demand lowers asset prices, reducing the value of collateral, which in turn leads borrowers to repay debt, exacerbating the original decline in aggregate demand. This “debt deflation” was first formulated clearly by Irving Fisher in the 1930s, and has recently been revived in a more sophisticated form by Nobu Kiyotaki and John Moore, here at the London School of Economics. Because deflations are, fortunately, few and far between, there is a lack of hard empirical evidence on the quantitative significance of debt deflation. In 1993, I argued that the depth of the recession in the UK and the US in the early 1990s was the result of debt deflation. Consumption fell more sharply than would have been expected given movements in incomes and interest rates, reflecting an unexpected fall in inflation and asset prices. The effects on consumption of negative equity in housing were particularly severe. The experience of Japan may add to our knowledge in this area, although, as shown in Chart 6, despite a stagnant economy over the past decade, deflation of consumer prices has not been especially large. And I am confident that all central banks will do their best to prevent the sample size of countries suffering from serious deflation from increasing. 5  See for example Pindyck and Solimano (1993).