However, the finding that policy should respond more gradually in the face of uncertainty is not a general one. For example, Söderström (2002) suggests that there is uncertainty about monetary policy’s ability to return inflation in the medium term, that may call for a pre-emptive response. BIS central bankers’ speeches  3  2. Consider all of the outcomes  In the presence of uncertainty, it is wise not to put all of one’s eggs in one basket, but rather to hedge against undesirable states of the world. That is something that market participants know well, and it means that financial asset prices reflect not only what is thought to be the most likely outcome, but also the full range of other possible outcomes and the probabilities attached to them. So what is implied by a literal interpretation of markets – including government bond and interest rate swap markets – is not necessarily a true reflection of what participants expect is going to happen. 5 For example, at the time we were producing the November Inflation Report, the market yield curve implied the first increase in Bank Rate would come in March 2017, and that it would reach 1¼% by the end of 2018. A literal interpretation of this would suggest that in 33 of the coming 36 months the majority of MPC members would have to return home to their respective dinner tables reporting they voted for no change in Bank Rate.
Retain flexibility  Of course one can never know exactly what the future holds. So when the time does come to raise Bank Rate, it will be important to retain the flexibility to change course if needs be, either by tightening policy more quickly than originally envisaged or by being prepared to loosen again. Were it required to respond to unforeseen events, the MPC would have two tools at its immediate disposal: Bank Rate and QE. Past experience gives us a good dataset from which to gain an understanding of how changes in policy rates transmit to the economy. Based on a rich literature of international estimates over the period since inflation targeting began, the peak impact on inflation is generally estimated to occur with a lag of between 18 and 24 months, although it begins to  5  See Shafik (2015) and Broadbent (2015) for more on this issue. 6  Though should proposed legislation pass, the number of MPC meetings per year will reduce from 12 to 8, in line with the recommendations of the Warsh Review (Warsh, 2014)  7  The market curve represents the mean of the priced distribution of interest rates. Consideration of risks can cause this whole distribution to move relative to true expectations. Risks can also affect the shape of the distribution, though Dison and Elliot (2015) found that the shape of the distribution is currently being heavily influenced by the proximity of Bank Rate to the effective lower bound.