of using those concepts for the month - to - month implementation of monetary policy. the natural rate, although clearly relevant to the dynamics of inflation, is not sufficient to explain changes in the inflation rate. the nairu, which is defined to be a measure related to short - run inflationary pressures, requires knowledge of the reduced form of the transmission mechanism and the history of shocks to the economy. but that knowledge is required also for a forecast for inflation, and so the nairu itself provides no additional information over that contained in the forecast. indeed, estimates of the nairu could be described as a by - product of the process of forecasting inflation. as an example, consider the impact of the appreciation of sterling from mid - 1996 until late 1997. retail price inflation can be thought of as a weighted average of domestic and imported inflation. the substantial real appreciation of sterling since mid - 1996 has for a while reduced the imported component of uk inflation and so, in turn, retail price inflation, below the level that it would otherwise have reached. in essence the nairu fell relative to the natural rate. that restraining effect on inflation will gradually wear off and begin to be reversed if sterling continues to fall. the issue of whether the domestic inflation component would fall to a level consistent with the inflation target by the time this temporarily depressing effect wore off was central to the monetary policy debate during the summer. the example of sterling ’ s appreciation shows how a macroeconomic shock, entirely independent of the labour market, can affect the relationship between the rate of unemployment and the rate of inflation. the rise in sterling is likely to have reduced the nairu via two separate channels. first, in the short run, the relationship between domestically generated inflation – of which wage inflation is a substantial element – and retail price inflation shifts because of lower imported inflation. second, the temporary improvement in the terms of trade that followed the rise in sterling in 1996 reduced the wedge between the real consumption wage – which is of relevance to employees and which reflects a mix of both domestic and imported inflation components – and the real product wage – which is of relevance to employers and which reflects the prices only of domestically produced goods. that reduction in the wedge is likely to have reduced the pressure on nominal wage growth for any given level of unemployment. so it is quite possible to believe that the nairu has fallen even if the natural rate has not. but this is likely to be temporary. as the impact of sterling ’ s appreciation on wages and prices

wears off, the nairu will, other things being equal, rise towards the natural rate. but other more – 5 – lasting changes may reduce the natural rate ( and hence the nairu ). for example, a range of government policies, including changes to the jobseekers allowance, the new deal and the new working families tax credit, have increased incentives to work. the national minimum wage works in the opposite direction. assessing the impact of these structural factors on the natural rate is no easier than calculating the effect of macroeconomic shocks on the nairu. but it is useful to distinguish the two concepts, not least because they can move quite differently in the short run. enough of this theory, some of which may appear largely semantic. none of it is, of course, either new or original. but understanding the language of unemployment matters. richard rogerson, in the journal of economic perspectives last year, posed the question : “ have the language and concepts developed by economists in their study of unemployment served their role of fostering clear communication of findings and allowing issues to be sharply defined? ” professor rogerson ’ s conclusion, you will perhaps not be surprised to hear, was a resounding no. neither the natural rate nor the nairu are terms well chosen to win friends and influence people. after all, there is nothing natural about the natural rate. whatever we call them, it is crucial to recognise that there is considerable uncertainty about the location of both the natural rate of unemployment and the nairu. even in the united states, where there appears to be no obvious trend in the natural rate, estimates of the 95 % confidence interval for the nairu are typically from 5 % to 7. 5 %. in the uk where both structural reforms and macroeconomic shocks have had a larger impact than in the us, the range of uncertainty is even greater. perhaps the most honest answer to the question of what is the natural rate was that given by milton friedman to the wall street journal in january 1995 : “ i don ’ t know what the natural rate is, neither do you, and neither does anyone else. ” the labour market and monetary policy in practice? how do these concepts affect monetary policy in practice? and what role does analysis of the labour market play in the monetary policy committee ’ s decisions on interest rates? using the language of unemployment developed earlier, the mpc has to assess whether the current level of unemployment differs significantly from the nairu and, as importantly, whether it is