consumer price inflation from year to year, but to reduce the degree of uncertainty over the price level in the long run because it is from that unpredictability that the real costs of inflation stem. the continuously compounded annual rate of inflation ( as measured by the cpi ) from august 1992 to august 2012 was 2. 1 %, and the average of the annual rates each august over that period is 2. 2 %. reinhart and rogoff ( 2009 ) present an array of evidence to document the cost of prolonged recessions following financial crises. leigh - pemberton ( 1992 ). bis central bankers ’ speeches the improvement in credibility of policy is shown by the fact that whereas in 1992 expected inflation, as measured by the difference between yields on conventional and index - linked gilts, was close to 6 %, today the same measure is around 2½ %. predictability of the price level is greater because over a long period inflation has on average been close to the target 4. even if inflation deviates from target – as will often be the case – it is expected to return to target, and so inflation expectations are anchored. 5 that is why since 2007 the uk has been able to absorb the largest depreciation of sterling since the second world war, as well as very large rises in oil and commodity prices, with an increase in inflation to an average of only 3. 2 % over the past five years and without dislodging long - term inflation expectations. so the framework has been tested and has proved its worth. but the current crisis has demonstrated vividly that price stability is not sufficient for economic stability more generally. low and stable inflation did not prevent a banking crisis. did the single - minded pursuit of consumer price stability allow a disaster to unfold? would it have been better to accept sustained periods of below or above target inflation in order to prevent the build up of imbalances in the financial system? is there, in other words, sometimes a trade - off between price stability and financial stability? 6 the intellectual foundations of monetary policy the experience of the past five years suggests that we reassess the intellectual framework underpinning monetary policy. 7 the emergence of inflation targeting, and the successful results in the form of the great stability, coincided with the development of the so - called new keynesian consensus on macroeconomic theory. this framework offered a theoretical foundation for flexible inflation targeting. central to the new keynesian view is the assumption that some prices are “

perhaps we should heed the advice of ricardo caballero, who has written that “ macroeconomic research has been in ‘ fine - tuning ’ mode within the local maximum of the dynamic stochastic general equilibrium world, when we should be in ‘ broad - exploration ’ mode ”. 14 so let me now move into broad exploration mode and give three examples in which a trade - off between monetary and financial stability might arise, and which could in theory justify a policy of aiming off the inflation target in order to reduce the risk of future financial instability, before i turn to whether such a policy would have been appropriate before the crisis. the first is where misperceptions about future incomes persist and are embodied in key prices, such as the exchange rate and long - term interest rates. households, businesses, and banks can all make big mistakes when forming judgements about the future, and make spending decisions today which they will come to regret when their true lifetime budget constraints are revealed. there is no mechanism for ensuring that misperceptions about the sustainable level of spending are corrected quickly. it may take many years before those beliefs are invalidated by experience. so an equilibrium pattern of spending and saving can emerge that is stable temporarily but not sustainable indefinitely. and misaligned prices may reinforce mistaken beliefs if people are using market prices to extract signals about future incomes and consumption opportunities. evidence of the persistence of misperceptions can be seen in the imbalances in the world, and especially the european, economies. i do not mean to imply that when economic agents make these mistakes they are behaving irrationally. rather that in a world of intrinsic uncertainty it is far from obvious how to make decisions. the assumption of rational expectations is very helpful for economists when trying to understand the implications of their own models – it is a discipline to prevent the drawing of arbitrary conclusions. in practice, however, households are on their own in a highly uncertain and complex world where they are learning from experience. when it comes to decisions about how much to spend and how much to save, expectations of future incomes are crucial. in the absence of a complete set of markets for future consumption goods – and labour – there is no mechanism to ensure that decisions today, and so the implied plans for tomorrow, will be consistent with the possibilities available in the future. if revisions to expectations of future incomes are uncorrelated across households, then aggregate spending will be relatively stable. the problem comes when many households have similarly over