To convince you of how important learning about key economic relationships is to decisions on monetary policy, let me show you two charts which illustrate some of the challenges facing the Monetary Policy Committee. A basic proposition common to most models of the economy is that if demand exceeds the supply capacity of the economy then there will be upward pressure on wage and price inflation. In the labour market supply capacity is often equated, in the long run, with a particular rate of unemployment. Chart 2 plots the unemployment rate against the inflation rate in the UK over the period 1993-2004. It shows the trade off between unemployment and inflation in the short run, also known as the Phillips curve. Unemployment fell from nearly 10% in 1993 to less than 3% in 2004. But – in stark contrast to the earlier post-war period – inflation remained virtually unchanged. How can we explain this phenomenon? Was it because the natural rate of unemployment also fell – perhaps as a result of labour market reforms enacted in the 1980s and 1990s? Or did the Phillips curve become flatter – perhaps because inflation expectations were anchored on the target so that deviations of unemployment from the natural rate generated less pressure on wages and inflation than before? Or was the outcome the result of a chance sequence of shocks that held inflation down?
See Capie and Wood (2001). BIS Review 36/2005  1  is the natural way to conduct policy when there is a great deal about its effects that we do not understand. The practice of monetary policy must recognise that monetary theory will continue to evolve. That is why my lecture is subtitled: practice ahead of theory. What can monetary policy do? In practice, monetary policy means setting the level of the official interest rate at which the central bank deals with the banking system.3 But ideas about how interest rates should be set, and with what objective, have been subject to radical changes since the 1970s. Let me give three examples. None is new; the subject has moved on. I give them to show that monetary policy operates against an everchanging backdrop of ideas about the way the economy works, a theme that lies at the heart of my lecture. First, it is now widely accepted that there is no long-run trade-off between output and inflation. Both theory – following Friedman and Phelps – and practice – particularly in the 1970s – showed that permanently higher inflation does not bring faster growth or higher employment, and may well reduce both. But in the post-war period views were different. In 1959 the Radcliffe Report on the Workings of the Monetary System seemed to support the idea of a permanent trade-off. The objectives of monetary policy included, it argued, “a high and stable level of employment” and “reasonably stability of the internal purchasing power of money”.