The correlation between the two series was a remarkable 0.85 during the period 2005 to 2011. 2 / 11  BIS central bankers' speeches  Admittedly, academics typically take this correlation much less seriously than practitioners. It is a good habit of academics to dismiss contemporaneous correlations between two variables as spurious. If anything, standard theory – also known as uncovered interest parity (UIP) – predicts a correlation between today’s interest rate differentials and tomorrow’s exchange rate changes, thereby discrediting any perceived contemporaneous causality. Other approaches are less dismissive, however. The “asset market approach” to exchange rates, for example – which, in essence, is an alternative representation of the UIP – posits that, as an asset price, exchange rates should fully reflect today’s expectations about the future, just as equity prices reflect the expected discounted stream of future earnings and other relevant information.5 The implication is that the current level of the exchange rate should be a function of the average of current and future expected short-term interest rates. And because monetary policy, away from the zero lower bound, predominantly sends signals about the current level of central bank interest rates, and because the term premium – the additional return that investors demand for the risks incurred by not simply rolling over a series of short-term bonds – was typically contained at shorter horizons, it is not surprising to see a strong correlation between short-term interest rates and the exchange rate.

This has widened output gaps and depressed inflation. In response, policymakers have provided unprecedented degrees of policy support – in a number of advanced economies, double-digit percentages of GDP in both Quantitative Easing (QE) and fiscal stimulus. These actions should stimulate activity, shrink output gaps and boost inflation. Chart 1: CPI inflation projection  Source: Bank of England. Notes: Projection from February 2021 Monetary Policy Report, based on market interest rate expectations, other policies as announced. 1  For example, Batini and Haldane (1999). 2  All speeches are available online at www.bankofengland.co.uk/news/speeches and @BoE_PressOffice  2  It is these heavy weights on either end of the inflationary see-saw which give rise to unusually large uncertainties around future inflation. If the hit to activity were to prove larger or longer, even this degree of policy stimulus may prove insufficient to return inflation to target. But if economies bounce-back as the vaccination programme is rolled-out, policy stimulus could over-stimulate the economy and, with it, inflation. There are few, if any, historical precedents to help judge the response of the economy to this scale of shock and degree of policy stimulus. And the costs of getting these judgements wrong could be significant. Costs for the economy, if policy is set either too tight (resulting in lost jobs and income) or too loose (resulting in policy needing to be tightened more than expected, causing future losses of jobs and incomes). And costs for central banks in damaged credibility, if inflation targets were to be missed persistently.