of the factors affecting the appropriate real policy rate. for example, see http : / / bankunderground. co. uk / 2015 / 08 / 11 / an - estimate - of - the - uks - natural - rate - of - interest /. all speeches are available online at www. bankofengland. co. uk / publications / pages / speeches / default. aspx “ an abstraction ; like faith it can only be seen by its works. one can only say that if the bank policy succeeds in stabilizing prices, the bank rate must have been brought into proper line with the natural rate, but if it does not it must not have been. ” in the period since the uk recovery gathered pace in 2013 and the august inflation report this year, bank rate was at ½ % and the stock of qe unchanged. uk headline inflation over that period was of course affected by externally generated disinflation pressure from the sudden and very substantial drop in energy prices. but over that period, the average of a range of measures of domestically - generated inflation in the uk fell from around 2 % to ½ % at the end of 2014 – it has since recovered but only to nearly 1½ % which is considerably below its pre - crisis average of 2½ %. over the same period, pay increases averaged around 2 % – despite the fastest drop in unemployment in 40 years. output growth picked up briefly to over 3 % but has now fallen back to nearer 2 %. and a small output gap probably persisted over the period. the mpc ’ s 2 % inflation target is for uk cpi as a whole not for domestically generated inflation. but if we want to get a cross - check on where monetary policy was relative to where the natural rate might have been over this period, we can observe that monetary policy was not able to get domestically generated inflation to the inflation target over the policy horizon. in other words, far from being exceptionally loose, policy with hindsight may even have been a little tight. if this is right and the natural rate is currently slightly negative, how can that low level be explained? the great shocks that hit the economy after the crisis have surely dissipated. what are the headwinds now pushing the natural rate down? there are i think three interesting candidate explanations for this. the first is that there are still strong demand headwinds pushing the natural rate down. these include fiscal tightening, weakness in the global economy, restoration of credit spreads to more

accounting for around 2½ % and term premia, which are much harder to estimate, are probably around 0 %, which leaves a trend rate of around zero. the natural rate of interest ( r * ) the second concept of the interest rate i want to look at today is the natural interest rate. the natural rate of interest is quite an old concept, first posited by knut wicksell at the end of the 19 th century as the rate of interest at any given time that keeps the price level stable. wicksell argued that if the market rate exceeded the natural rate, prices would fall ; if it fell below, prices would rise. the economics discipline then went on an intellectual journey over the 20 th century, first largely abandoning the natural rate concept in favour of keynes ’ advocacy of fiscal policy for demand management and then returning to monetary policy, albeit in the form of the famous quantity theory of money. by the start of the 1990s, however, the difficulties of targeting the growth in monetary aggregates were clear and central banks turned to interest rates as the principle instruments of policy. nowadays, we tend to think of the natural rate not so much as the rate that would hold prices stable at any given time but, given frictions in the economy and lags in the impact of monetary policy, as the interest rate that will close the output gap over the monetary policy horizon. however, unlike the trend real rate, the natural rate is a shorter - term concept. the trend real rate as we have seen is determined by slow - moving structural factors that determine the underlying balance of the supply of savings and the demand for investment. but the interest rate necessary to offset the impact of unexpected outcomes – shocks – hitting the economy can vary significantly around the trend real rate over an economic cycle. over the economic cycle, the natural rate will lie below the trend real rate when the economy needs stimulus to offset a negative demand shock and above it when demand needs to be reined in. the actual monetary policy rate, bank rate in the uk, may well deviate from the natural rate – for example, if there are so - called ‘ trade - off inducing shocks ’. these are best thought of as shocks that would still move inflation away from target even if we were to perfectly match demand and supply. such shocks include a all speeches are available online at www. bankofengland. co. uk / publications / pages / speeches / default. aspx shock to the exchange rate