, autonomous shock to the exchange rate would ultimately change the price level not the inflation rate. but this particular shock probably reflected a reappraisal of real uk economic performance in the light of the financial crisis rather than, for example, interest rate differentials between the uk and its major trading partners. 3 during the decade prior to the crisis – the nice or non - inflationary, consistently expansionary decade – the uk experienced an unparalleled run of sustained growth, falling unemployment and low, stable inflation. but the economy also became badly unbalanced – overly dependent on domestic demand and with a trade deficit that was steadily expanding relative to domestic output. the real exchange rate change brought about by the depreciation of sterling ( and indeed the increase in vat ) reflected a need to rebalance the economy away from domestic expenditure and towards net exports. that real exchange rate shock will cause a change in relative prices, with import prices rising relative to domestic wages and prices. it may take several years for that price level effect to work through fully, generating higher inflation rates for the duration. it is possible, but by no means certain, that this effect has now worked through. a key and recurring theme in setting monetary policy is that one has to look at the source of the shocks to understand their inflationary consequences and judge the appropriate policy prescriptions. the first question i want to address today is, given our inflation target, what is the right monetary policy response to these shocks? i then want to talk a little about how we make such decisions and, in particular, the role played by models and forecasts. how should monetary policy have responded to the recent shocks to inflation? the economics profession has long accepted that different shocks warrant different policy responses. assume for a moment that one can perfectly identify the source and nature of a shock to the economy ( which of course, one never can ). faced with a demand shock – such as an exogenous increase in consumer spending ( for example driven by a change in preferences ) – inflation and output would be pushed in the same direction. the monetary for example, policy rates in the united states were being cut well before those in the uk. bis central bankers ’ speeches policy prescription in such cases is relatively simple – monetary policy just has to lean against the demand shock sufficiently that inflation returns towards the target. tightening policy helps to reduce the deviation of both inflation ( from target ) and output ( from its sustainable path ) albeit with somewhat different time la

remarkably – the uk is no more productive than it was back in 2005 – before jake bugg got his first guitar. the critical questions are how much and how quickly productivity improves. the mpc ’ s central view is that productivity growth is likely to pick up only slowly in the early phase of recovery, but that there is potential for growth to accelerate as the recovery takes hold. the slow pickup in productivity means unemployment could initially fall quite rapidly, but fall short of 7 %. over the next three years productivity is expected to grow at around 1. 8 % per year, below its pre - crisis trend3 of 2. 2 %. while even that modest productivity recovery is not assured, it is hardly an aggressive forecast. it implies that productivity reaches its 2008 level only in 2015. and it means that productivity doesn ’ t catch up any of its current 15 % shortfall relative to its pre - crisis trend. were any productivity catch - up to happen, unemployment could take even longer than three years to reach the threshold. a rebound in productivity, if accompanied by higher output growth, would be no bad thing. it would boost the incomes of those in employment and is an essential part of improving the uk ’ s competitiveness. moreover, in such a scenario, you would know to expect interest rates to stay lower for longer, encouraging household spending and business investment. our forward guidance is a stabiliser – securing the scale and duration of recovery that is needed to bring unemployment down. the prospect that interest rates might stay at their low level for longer will not be welcome for savers. i have tremendous sympathy for them – after all they have done the right thing, set money aside, and now they are earning returns that are substantially below what they would have expected. but raising interest rates now is not the answer – instead what savers need is a stronger economy. that will mean higher asset prices, and will allow interest rates to return to normal levels in a sustainable way. a strong economy is in all of our interests, as it will deliver better job prospects for our friends, neighbours, children and grandchildren. the last thing savers want is for the uk to follow japan by raising interest rates before recovery is secured, only to find that we are condemned to decades more of low interest rates and lost opportunities. our forward guidance is about setting the path of inflation to return to target let me reassure you that our mandate to deliver price stability has not changed. our inflation target of 2 % was rec