They all kick off with the same unwelcome economic conditions, presumably caused by some prior, off-stage shock to costs: inflation is 2% points above the target, output’s 1% point below potential and official interest rates are at (what is assumed to be) their “neutral” rate, which is assumed not to change. All three simulations also have inflation back at target two years later. But each involves a very different means of getting there. In the first, the policymaker – call it Committee A – hikes Bank rate immediately and aggressively, by 2% points. This rapidly pushes the economy into recession, making the output gap even larger. But it does at least succeed in bringing inflation back to target pretty promptly, well within the two-year point. Indeed, inflation then falls somewhat below target thereafter, and interest rates fall back sharply, to a level below where they started. Perhaps “A” stands for “austere”, or (hyper) “activist”. Committee B – “balanced”, maybe? – is a little gentler in its approach. Recognising that a significant existing output gap will do some of the work in reducing inflation it raises rates only a touch. Inflation therefore takes longer to come back to target. But it just about gets there by the two-year point and, in the interim, the real side of the economy suffers less and interest rates are less volatile. Finally, just for effect, I’ve added a Comedy MPC (Committee C).
Gabaix Xavier 2012, “Variable rare disasters: an exactly solved framework for ten puzzles in macro-finance”, Quarterly Journal of Economics, Volume 127, Issue 2, Pp. 645–700. Joyce M. and A. Meldrum, 2008, “Market expectations of future Bank rate”, Bank of England Quarterly Bulletin. Macaulay Frederick, 1938, “Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields, and Stock Prices in the United States Since 1856”, National Bureau of Economic Research, pp. 33. Mankiw G., and L. Summers, 1984, “Do long-term interest rates overreact to short-term interest rates?”, Brookings Papers on Economic Activity. Shiller Robert, 1979, “The volatility of long-term interest rates and expectations models of the term structure”, The Journal of Political Economy, Vol. 87, No. 6, pp 1190–1219. BIS central bankers’ speeches  9  Sutton Gregory, 1997, “Is there excess comovement of bond of bond yields between countries”, Bank for International Settlements, Working Paper No. 44. 10  BIS central bankers’ speeches