In other words, some trade-off between inflation and output has become possible and lambda has become relevant. As I mentioned earlier, the period of inflation targeting can be divided into pre- and post-crisis periods. During the Great Moderation, the economy’s supply capacity grew at a steady pace, and, for the most part, 15  In New Keynesian models, the slope of the Phillips Curve is related to the deep parameters governing the frequency with which firms are assumed to be able to re-optimise their prices, following the formalisation of Calvo (1983). See Calvo, G (1983), “Staggered prices in a utility-maximising framework”, Journal of Monetary Economics, 12. 9  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches  9  deviations of inflation from target reflected temporary disturbances to demand that were expected to drive output and inflation in the same direction (Chart 1). 16  Generally, monetary policy faced few trade-offs; divine  coincidence largely ruled. The crisis brought shocks both to demand and supply, higher inflation and large shortfalls in output and employment. The era of divine coincidence was over and the MPC had to balance a series of challenging trade-offs (Chart 2). What can be learned about lambda from this era? Taking these trade-offs at face value suggests a value of lambda of between 0.1 and 0.2 for the inflation targeting period as a whole, on the basis of data outturns 17  (Chart 6) and on the basis of MPC forecasts (Chart 7).
Over the  16  same period, unemployment averaged 7.6%, with a  14  standard deviation of 2.8%. Soon after the adoption of  12  inflation targeting, unemployment fell by one  10  percentage point and its standard deviation was cut in  8 6  half. The volatility in economic growth rate in the  4  1970s and 1980s was also one-and-a-half times  2 -6  -4  -2  6 8 Output gap (%) Source: Bank calculations. Inflation is the annual growth rate of the retail price index (RPI) until 1975, and the annual growth rate of the retail price index excluding mortgage interest payments (RPIX) after 1975. The output gap is the percentage deviation of quarterly GDP from its trend, where the trend is measured by a Hodrick-Prescott filter. 0  0  2  4  higher than after the adoption of inflation targeting. In sum, high, volatile inflation likely contributed to a higher natural rate of unemployment and poor supply side performance. Once the UK adopted inflation targeting and granted  operational independence to the Bank, consistent with the theory of constrained discretion, the UK moved towards a better equilibrium characterised by low, stable and predictable inflation, and relatively stable employment. Moreover, by successfully anchoring inflation expectations around the target, inflation targeting helped lower UK borrowing costs for households and businesses, and has allowed monetary policy to promote short-run stabilisation of the economy.