The Great Stability appeared to be a permanent break from earlier periods – periods when monetary policy exhibited more unpredictable behaviour and left the economy to the north-east of the Taylor frontier (Chart 2). And in one important sense it was – the dark days of double-digit inflation were consigned to the past. 1  The inflation measure used is the quarterly rate of increase of the GDP deflator, defined as the ratio of nominal GDP to real GDP. The output gap is estimated as the difference between the log of real GDP and the trend path of log GDP, derived using the HP-filter. Source: ONS and Bank of England calculations. BIS central bankers’ speeches  1  But the Great Stability was not representative of a new normal. The variance of the output gap – though not inflation – has been much higher over the past five years as the financial crisis generated a deep recession (Chart 3). So what have we learned? The banking and broader economic crisis has demonstrated that macroeconomic policy can face an additional trade-off between ensuring the soundness of the financial system in the medium term, and keeping output in line with potential output and inflation on target in the near term. Such a trade-off arises because financial vulnerabilities can build even while output is growing steadily and inflation is low and stable. Let me give three examples of the sort of underlying mechanisms at play.
The MPC remains committed to achieving its 2% inflation target but subject to that, and to continuing financial stability, Bank Rate will not be raised until we have seen unemployment fall to at least 7% so we can explore just how much spare capacity there is in the economy. Meanwhile the Funding for Lending Scheme continues to support the supply of credit in the UK and has become more focussed on encouraging lending to SMEs. The outlook – as always – remains very uncertain. But it is certainly a brighter picture than it was a year ago, and with policy set to be supportive, there are good reasons for expecting that improvement to continue. 12  BIS central bankers’ speeches