Looking closer at individual sectors reveals that productivity was significantly boosted by very high growth in manufacturing sector productivity in the decade before the financial crisis, much faster than in the preceding 25 years. This is the period sometimes referred to as the ‘Great Moderation’, a period characterised by unusually low volatility in both economic activity and inflation. But following the financial crisis, manufacturing productivity growth fell back sharply. This fall in manufacturing productivity is the main cause of the slowdown. The reasons behind it are much debated – and productivity may be harder to measure in the modern economy where businesses invest as much in intangible capital, like software and branding, as in physical capital, like buildings and machinery. Measurement problems could be a big part of this. But much also points to structural change. Perhaps new ideas have become harder to come by, or perhaps technological innovation and specialisation have faded as globalisation slowed. Bank of England  Page 8  Whatever the reason, when productivity growth is weak, companies gain less from installing new capital. So weaker productivity growth has meant that firms have sought to borrow less to finance investments at a given interest rate. This reduction in the demand for capital has lowered the equilibrium rate. The second important factor is population ageing.
Over the short term, moreover, the actual equilibrium interest rate, r*, will fluctuate around the trend level, R*, driven by shorter-term influences from both demand and supply. This is what matters for monetary policy here and now. Why? Because r* is the rate at which demand is in line with supply so that there is no output gap – neither excess demand nor excess supply in the economy. Responding to shifts in r* is what helps keep inflation close to target. This does not mean that monetary policy should always align Bank Rate exactly to r*. Sometimes, monetary policy faces trade-offs between inflation and the balance of supply and demand. But it does mean that supply matters for monetary policy also in the short run. By determining the level of demand the economy can sustain without generating excess  Bank of England  Page 10  inflationary pressures, it affects the appropriate level of interest rates, effectively by setting the speed limit for the economy. And when shocks drive inflation away from target in the way we have seen, monetary policy responds by steering demand to a level – relative to supply – that ensures that inflation returns to target sustainably. Monetary policy cannot affect this level of supply. But the level of supply will affect the appropriate setting of monetary policy. It matters, therefore, that big shocks to the economy have weighed heavily on supply in recent times.