They too cause large losses of income by a large number of people at the same time. In other words, they have all the hallmarks of a dread event, albeit one associated with economic, rather than physical, insecurity. The Great Depression was the most prominent example of an economic dread event in the 20th century. Historical accounts point clearly to it having generated an exaggerated sense of insecurity (Galbraith (1954)). One way this manifest was a surge in demand for safe assets. In Friedman and Schwartz’s words: “Expectations of great instability enhanced the importance attached to accumulating money and other liquid assets”. In the 1930s, this search for safety resulted in a rise in the demand for, and price of, government securities, lowering their yield. The yields on US and UK government bonds fell significantly and persistently during the 1930s (Chart 6). Insecurities revealed themselves in securities. The Great Depression also widened the gap between the return on safe and risky assets such as equities. This wedge – the equity premium – appears to have risen sharply after the Great Depression. It remained elevated for several decades thereafter. In finance circles, this is known as the “equity premium puzzle” (Mehra and Prescott (1985)). Recent academic evidence has argued, persuasively, that this puzzle can be solved by recognising that the Great Depression, and other catastrophic output losses, are dread events which exaggerate and prolong risk perceptions. Catastrophe risk then explains the size and persistence of the equity premium (Cogley and Sargent (2005), Barro (2005)).

That drags down the yield curve by an amount equal to the probability of recession multiplied by the lower interest rate bound. As recession probabilities dominate over medium-term horizons, so too does the magnetic attraction of the lower bound on the yield curve. There are plausible reasons why financial markets might currently be over-pricing recession risk, causing an excessive downdraught to the yield curve. Psychological scarring is one such explanation. Nonetheless, historical experience suggests these recessionary fears are  7  6  These probabilities are drawn from estimated distributions using data from interest rate options contracts. BIS central bankers’ speeches  not unreasonable. Those fears provide a plausible explanation for why interest rates are, and are expected to remain, resolutely stuck to their floor. Monetary policy implications Given these risks, what are the implications for monetary policy? Growth in the UK remains solid. Robust private sector demand has been a key contributor, with household consumption growing steadily for two years, largely funded by a pickup in real incomes. Despite some signs of slowing recently, business investment has also remained robust. We have seen a reasonable, and reasonably balanced, recovery. The forecasts for GDP and inflation contained in the Bank’s May Inflation Report envisaged these broad patterns continuing. Growth was expected to remain around its historical average rates over the next few years, while inflation was expected to rise from its current near-zero rates to reach 2% after two years.