During the mid and late 1990s we did not cut the repo rate as much as our normal principles might have recommended, as our assessment was that some of the fall in prices was due to our own interest rate cuts, which subdued the housing cost component of CPI, and to deregulation that was partly of a temporary nature. In the same way, we did not react as much as we could have done when inflation rose sharply for transient reasons in 2001 and 2003. A more recent example is the decision in March 2005 not to cut the key rate. Our reasoning then was that it might have been possible with the inflation forecasts we had, but that the expected high growth, combined with elevated house prices, called for some caution. Our flexibility can also be said to include a preparedness to react to events where the final consequences are particularly difficult to survey. One such example is the acts of terrorism in the United States on 11 September 2001. In the wake of these attacks, many central banks around the world were quick to cut interest rates. This powerful response can be interpreted as a kind of "insurance" against a really poor outcome, rather than as the result of carefully-considered assessments of the most probable outcome. It would be desirable, for a better understanding of monetary policy, to develop the principles governing how our reasoning in practice weighs future inflation against real or financial stability.
Similarly, the current unemployment rate of 9 percent is well above most estimates of the nonaccelerating inflation rate of unemployment (NAIRU) – the lowest rate of unemployment consistent with sustained price stability. In the pre-crisis period, the NAIRU was likely in the region of 4.5 percent to 5 percent. There are several reasons why the NAIRU may now be higher. First, extended unemployment compensation benefits create incentives for prospective workers to keep looking for better jobs rather than accept less attractive positions. Empirical work on this subject suggests that the NAIRU might currently be roughly 1 percentage point higher because of this factor. However, this effect will only persist for as long as the extended benefits are in place. Second, the rise in unemployment has been associated with an increase in the degree of mismatch between unemployed workers’ job skills and available job vacancies. Some cite the upward shift in the Beveridge curve, which illustrates the relationship between unemployment and job vacancies (Chart 22), as evidence of this effect. Third, the longer that people are unemployed, the more their skills tend to atrophy, which makes it harder for them to become employed in the future. For unemployed workers, the median duration of unemployment has climbed and a growing proportion of the unemployed has been jobless for long periods (Chart 23).