The Great Moderation 20 years on – and beyond – speech by Catherine L. Mann

Introduction

In 2004, 20 years ago, a Federal Reserve Board Governor at the time, Ben Bernanke, gave a speech titled “The Great Moderation”. He outlined how, over the preceding 20 years, macroeconomic volatility had declined substantially and attributed this to three candidate explanations: first, structural change (such as improved economic institutions, technology, etc.), second, better macroeconomic policies (including but not limited to monetary policy), and third, simply good economic luck. In his speech, Bernanke concluded that the stability enjoyed from the mid-1980s was not primarily good luck, and that improvements in the conduct of monetary policy played a significant part.

Today I am revisiting this question, with another 20 years of data. These 20 years have been defined mostly by continued macroeconomic stability, albeit punctuated by a number of major economic and societal crises with long-lasting ramifications. I will look both through a global lens and from the perspective of the UK, a small open economy that has experienced not only the global, but also domestic shocks.

Then I’m going to consider ‘beyond’, i.e. the outlook for the future. Even though making predictions is foolish, I am going to venture one anyway: over the next few years at least, volatility in macroeconomic variables likely will be elevated.

Why do I expect macroeconomic volatility to be more elevated? A series of global economic challenges lie ahead to which policies will respond, likely in different ways. Direct effects and spillovers from other countries to the UK are inevitable. Higher volatility may come from global challenges, such as the physical effects of climate change, as well as from economic effects of the transition to net zero.^{footnote [1]} It might come from trends towards global fragmentation, through politically aligned ‘friend-shoring’ and an increasing incidence of protectionist trade policies and sanctions. It might come from more active use of fiscal policy as well as industrial policy initiatives, that also yield a build-up of debt. It might be more associated with domestic factors, such as the interaction among demographics, investment, and disparate absorption of AI-related technological change, which affects average productivity growth and its dispersion across firms and regions. It might be from some ‘traditional’ sources of volatility – geopolitical tensions and energy markets. Given this long list, it would not be surprising if that element of good luck present over the last 40 years might have run out.^{footnote [2]}

What role will monetary policy have to play in this likely more volatile environment? Monetary policy is one of the most important macroeconomic stabilization tools. A macroeconomic environment characterized by stability and low uncertainty supports economic growth because it encourages households and firms to make – not postpone – consumption and investment decisions. Macroeconomic stability and the belief and trust that central banks will act to achieve it matters to anchor expectations. This also supports the effective functioning of monetary policy, its transmission through the economy, and reinforces central bank credibility.

If the Great Moderation had a heavy dose of good luck, we might need to reconsider some of the fundamentals of how we believe monetary policy works. If it was mostly good policy, still we cannot just rest and celebrate success; we must continuously act to confirm this trust. Monetary policymakers need to reinforce public beliefs in their ability to bring about macroeconomic stability by achieving it. My responsibility is to uphold the ‘good policy’ contribution to a continued Great Moderation, most likely in the face of ‘worse luck’.

What underpins the Great Moderation?

Great moderation in the data

In the central banking world, when asked about the benefits of inflation targeting and independent central banks, we often refer to the Great Moderation as its greatest achievement, by achieving significant reductions in macroeconomic volatility. This is often attributed to the provision of a nominal anchor (see for instance Giannone et al., 2008).^{footnote [3]} Chart 1 plots inflation volatility across the UK, US, and euro area. The first observation is the decline in average volatility from before, to during, the Great Moderation period (shown in dotted lines). The second is the apparent co-movement of inflation volatility between them. And third is that UK volatility is higher than the other two regions, both on average and particularly during peak volatility periods.

Chart 1: Inflation volatility across countries

Standard deviations in percentage points

Footnotes

• Source: Bureau of Economic Analysis, LSEG, ONS and Bank calculations.Notes: Chart shows monthly data from 1960 to September 2024. Inflation volatility is calculated as a rolling 12-month standard deviation of year-on-year percentage changes in CPI, 6-month moving averages are shown. The UK inflation series is CPI, while the US inflation series refers to Personal Consumption Expenditure. For the euro area, the inflation rate (CPI) is calculated as a simple average of the individual “big 5” country inflation rates – Germany, France, Italy, Spain and the Netherlands. Dotted lines show the average volatility over the 1960-1983, and 1984-2019.

The start of the Great Moderation, in the US, is usually marked in the 1980s, when Paul Volcker and later Alan Greenspan were Federal Reserve chairs. In the UK, this period is thought to begin somewhat later, around the 1990s. The Great Moderation not only reduced inflation volatility. Chart 2 shows annual inflation over time across these jurisdictions, where the comovement across jurisdictions is even more striking. Once again, inflation spikes are greater for the UK than for the others.

Chart 2: Realized inflation across countries

Year-on-year percentage changes

Footnotes

• Source: Bureau of Economic Analysis, LSEG, ONS and Bank calculations.Notes: The UK series shows CPI, while the US series is Personal Consumption Expenditure. For the euro area, the inflation rate (CPI) is calculated as a simple average of the individual “big 5” country inflation rates – Germany, France, Italy, Spain and the Netherlands. Dotted lines show the average inflation rate over the 1960-1983, and 1984-2019.

Both inflation volatility and mean inflation fell over the last decades of the 20^th century and into the 21^st. Across all three jurisdictions, inflation averaged close to 2%. The two moments of inflation – volatility and mean – are related through the key ingredients of inflation expectations, nominal rigidities, and associated persistence. In the post-WW2 period, an increase in trend inflation is associated with a more volatile and unstable economy, which also tends to destabilize inflation expectations. Similarly, when inflation is low shocks dissipate more quickly.^{footnote [4]}

To understand whether this period of low macroeconomic volatility will continue, we need to assess the fundamentals of the Great Moderation period. Was it really monetary policy institutionalizing a nominal anchor, including (for a time) exchange rate stabilization? Or did other policy areas, such as a more disciplined fiscal regime play a significant role? Is it mostly because until recently, countries hadn’t experienced an energy shock like that of the 1970s? What about the role of globalization and technological change? Were individual countries’ policies mainly the story, or is it more spillovers and global phenomena?

By now, there is a vast literature on potential causes of the Great Moderation which can be broadly split into two schools of thought: good policy or good luck. Perhaps understandably, central bankers tend to come down more on the former.^{footnote [5]}

Good policy?

Part of the story that supports the good policy hypothesis rests on what we think went wrong in the 1960s and 70s. Inflation expectations were on the rise in the late 60s and early 70s following two decades of robust economic growth post-WW2. Increases in nominal policy rates by central banks did not keep pace. The resulting real interest rate was too accommodative (Chart 3), which led to accelerating inflation.

This was not just a UK phenomenon. In the US as well, Clarida, Galí and Gertler (2000) show that the pre-Volcker monetary policy rule allowed for self-fulfilling inflation dynamics, because nominal rates were raised by less than expected inflation. Using a theoretical model to simulate the US economy under different policy rules, the research shows that introducing inflation expectations into the policy rule (or in other words, policymakers paying attention to both nominal and real interest rates) stabilized inflation.^{footnote [6]}

Were monetary policymakers ‘asleep at the wheel’? Not really, because the role for inflation expectations, the value of having a monetary anchor, and a central bank’s commitment to achieve it were less recognized back then. Additionally, the mismeasurement of important economic concepts, such as the output gap and the degree of monetary restrictiveness also have been culprits.^{footnote [7]} Nevertheless, the good policy argument relies on the idea that shocks propagate differently in an economy where monetary policy both provides a nominal anchor and credibly responds to stabilize the economy following such shocks.

The role of the nominal anchor, financial markets, and inflation expectations are subsumed into something else: How monetary policy is conducted depends not only on the varying understandings of the monetary policy process but also on differences in remit. The central bank’s institutional framework matters.

Let’s take a closer look at the history of the monetary policy framework in the UK. Over the second half of the 20^th century there was considerable volatility in the monetary regimes themselves.^{footnote [8]} As observed from Charts 1 and 2, inflation and inflation volatility over the 1970s and 80s was considerably higher in the UK than the US or euro area.^{footnote [9]} It suggests that instability in institutions contributes to volatility in economic outcomes.

How have UK monetary strategies and institutions changed over time?

1. The UK was under a fixed exchange rate regime under Bretton Woods from 1948-1971; the fixed (but adjustable) value of sterling relative to the US dollar was a nominal anchor.^{footnote [10]} When the US ended the convertibility of the US dollar into gold in 1971, currencies including sterling, became free-floating.
2. During the period 1971-1976, there was no obvious nominal anchor in the UK. This also coincided with a period of extremely high inflation in the UK (a statement about correlation not causality at this stage).
3. It was not until 1976 (to 1987), that monetary targets were introduced: Following the success of the Volcker strategy, monetary policy aimed at controlling monetary aggregates.^{footnote [11]}
4. Between 1987 and 1992, the UK entered an exchange rate targeting regime by joining the ERM in 1990. While a nominal anchor was in place, by setting interest rates such that sterling was in a target range to the Deutschmark, monetary conditions were essentially imported from abroad.^{footnote [12]} As macroeconomic conditions diverged between the UK and Germany, the monetary policy repercussions to maintaining the regime were too strict, and the UK exited the ERM.^{footnote [13]}
5. Following sterling’s exit from the ERM in 1992, inflation targeting was formally introduced in the UK, under the control of the Chancellor of the Exchequer, until in 1997, the independent MPC was founded and tasked with achieving price stability.^{footnote [14]}

With such institutional volatility, it is perhaps not surprising that inflation and output were also volatile. As my former colleague Jonathan Haskel has argued, the independence of UK institutions helped deliver low inflation variability. Moreover, this brief history on the monetary framework in the UK highlights that there was no clear separation between fiscal and monetary policies until the establishment of the MPC with operational independence in mid-1997 and the adoption of the inflation remit (Bordo, Bush, and Thomas, 2022). In this, the UK differs from international peers. But its peers also had an earlier independence and more explicit, even if multiple, goals.

In the US, operational independence for the FOMC was established in 1933, and the Treasury-Fed Accord of 1951 gave the Fed the ability to pursue independent monetary policy.^{footnote [15]} With the launch of Bretton Woods in 1958, the Fed’s nominal anchor was the fixed exchange rate to the price of gold. With the gold standard abandoned in the 1970s, the Federal Reform Act of 1977 explicitly directs the Fed to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.^{footnote [16]}

From the 1970s until 2012, when the Fed formally adopted an explicit 2% inflation target, various tools were used to balance the dual mandate. Between 1970 and 1979, interest rates were the primary instrument of monetary policy – during this period it periodically also announced targets for money growth. When Volcker became chair in 1979, this switched to a commitment to inflation, executed through reserves targeting, at the cost of interest rate volatility. After 1982, the Fed focused more on interest rates as a tool to guide inflation (Bernanke and Mishkin, 1992).

For the euro area, the establishment of the ECB in 1998, and the launch of the euro shortly thereafter was a clear landmark for the provision of the nominal anchor through the ECB’s independence to pursue its quantitatively defined price stability target of below 2% inflation.^{footnote [17]} Before this, monetary policy was in the hands of national central banks. Since I don’t have time to discuss all these separately, and because it played a leading role in monetary policy of the economic area at the time, I will focus on the Bundesbank.

Following the break-up of Bretton Woods, the Bundesbank created a very explicit nominal anchor by setting targets for inflation and monetary growth, with flexibility relating to evolving economic conditions (i.e. it did not need to meet its monetary growth goals if inflation was under control), and it set interest rates to achieve this. The first reference to a 2% inflation goal was in 1986.^{footnote [18]} Already in 1957, formal legislation under the Deutsche Bundesbank Act created monetary policy independent of political influence (Clarida and Gertler, 1997).^{footnote [19]} The German reunification, combined with strong output growth in 1990 led the Bundesbank to tighten policy aggressively – which created a problem for the survival of the European Monetary System, as other countries that had pegged their currencies to the Deutschmark struggled to keep similarly tight policy to uphold the fixed exchange rate.

A few takeaways from the different monetary frameworks across economic areas, historically, is that 1) the UK was somewhat of an outlier in the tight fiscal control of monetary conditions over most of the 20^th century, 2) the UK had considerable variability in the nominal anchor (notably no anchor at all for a while), and 3) monetary conditions in these areas were linked and interdependent – most obviously at times of fixed exchange rate regimes, but also at other times simply through interlinked economies (whether through trade or financial markets).

On this last point, as a small open economy, when I say good policy, I cannot just mean UK monetary policy. To assess the good policy hypothesis, we should think about both the contribution from domestic, as well as global monetary policy. This is particularly true when we consider the increasingly important role for financial markets in intermediating monetary policy. In a world of global financial cycles (e.g. Miranda-Agrippino and Rey, 2020), policy spillovers matter. But, in a world of a global financial cycle (typically thought to be led by US conditions), the trilemma – where a country chooses only two out of the following three: free capital mobility, monetary independence, and a floating exchange rate – is reduced to a dilemma (Rey, 2015). In the presence of free capital mobility, Rey suggests that a global financial cycle dictates that the dominant country’s monetary policy constrains other monetary policymakers, regardless of exchange rate policy. So while we think of UK policymakers as affecting UK macroeconomic variables, international spillovers from policy in other countries matter a lot for a small open economy.^{footnote [20]}

In that case, was the Great Moderation about good US policy? Barnichon and Mesters (2023) evaluate the performance of the Fed since its inception, by comparing the distance of the revealed reaction function to an optimal reaction function. The authors find that only over the last 30 years (1990-2019), did the Fed’s reaction function deviate less from optimal.^{footnote [21]} So yes, good US policy, but maybe not exclusively. Ellis, Mumtaz and Zabczyk (2014) find that, for the UK, monetary policy had a bigger impact on inflation, equity prices and the exchange rate during the inflation targeting period than before.

Once the nominal anchor is established, it is the responsibility of monetary policymakers to keep it in place to achieve and maintain macroeconomic stability. We typically talk about the anchor in the form of economic agents’ long-term inflation expectations, which should remain at the 2% target, even in the face of shocks. Systematic policy during the Great Moderation years (meaning fewer policy surprises), alongside an emphasis on clear and effective communications of monetary policy decisions to the public has enabled financial markets and the broader public to gauge monetary policymakers’ reaction functions. Agents observe how monetary policymakers react to deviations from the inflation target and incorporate this into their expectations for interest rates and inflation in the future, resulting in the next monetary policy response being expected, rather than a surprise. Communications, as well as actions are required to reinforce that commitment to achieving the target. A key issue if inflation rates and volatility increase, is the potential for more policy surprises, as central bankers are challenged to appropriately interpret the changing environment and react accordingly.

Before I turn to the ‘good luck’ hypothesis, there is one last angle on good policy I would like to discuss. Particularly in the context of the UK institutional set-up where the government played a large role in macroeconomic stabilization, broadening our considerations of ‘policy’ beyond monetary policy is implicit. Fiscal policy matters too. The post-WW2 era of fiscal policy focused on avoiding the deprivation of the 1930s, where unemployment was high and living standards suffered. While one explanation for the focus on growth would be to say that the unemployment-inflation trade-off was not well known at the time, another is that, implicitly, policymakers were just placing a high weight on employment (‘lambda’, see Carney, 2017), at the cost of inflation. The tools of fiscal policy matter, too. During the 1970s, in an effort to control surging inflation, a series of pay freeze acts and price controls were put in place in the UK, aimed at limiting wage increases. However, these policies were poorly designed (by being linked to inflation) such that, in combination with bad luck, large pay increases resulted as the first oil shock hit.

In reality the assessment of good or bad policy is an oversimplification of the world. In practice, it may simply be a case of better policy than over the mid-to-end of the 20^th century in the UK. To quote Ben Bernanke again, ‘Monetary policy can be a powerful tool, but it is not a panacea’^{footnote [22]} So while we learn from historic experience to continuously improve how we conduct monetary policy, institutions change as the structure of the economy evolves, and monetary policy needs to evolve too.

… (and)/or good luck?

An alternative explanation, either dominant or supportive to the good policy argument, is good luck. Has it been the case that either the global and/or the UK economy have been hit by fewer shocks, smaller ones, or perhaps a different set of dynamics entirely.

Benati (2007) tests the hypothesis that monetary policy was not sufficiently stabilizing in the 1970s and 80s, which gave rise to multiple equilibria and self-fulfilling dynamics that caused inflation to surge. Using evidence for the UK in a time-varying parameters structural VAR with stochastic volatility, the author finds that the “great inflation” was largely due to non-policy-related demand shocks, as well as (to a lesser extent), supply shocks. They show: 1) that applying a post-1997 monetary policy rule to the 1970-80s period would not have materially changed outcomes, and 2) that applying a 1970s monetary policy rule to the whole sample period also does not change anything about the Great Moderation period, therefore concluding this was good luck rather than good monetary policy. Their results are in line with other papers for the US, e.g. Stock and Watson (2002), Primiceri (2005), Sims and Zha (2006), Canova and Gambetti (2006), Gambetti, Pappa, and Canova (2008), and Benati and Mumtaz (2007).

To further explore the good luck hypothesis, and to understand which combination of shocks have driven UK macroeconomic variables, Bank staff have developed a new structural VAR model^{footnote [23]} that features a rich combination of both domestic and global shocks, such as demand and supply, monetary policy, and risk, that can help explain why macroeconomic variables have moved the way they have.

Chart 4 shows a model-implied historical decomposition of UK CPI inflation into its underlying drivers, where I group together the impacts from global and domestic shocks respectively. Global shocks have played a strikingly large role in driving UK inflation and have frequently dominated domestic shocks. Taking together this evidence and the context of the UK as a small open economy, it is clear that global shocks and spillovers therefore should not be underestimated in their role of determining UK prices, and therefore implicitly incorporated into the monetary policy decision-making process.

Chart 4: SVAR-implied historical decomposition of CPI inflation

Year-on-year percentage changes

Footnotes

• Source: Brandt and Burr (mimeo).Notes: The chart shows the historical decomposition implied by the pointwise mean across accepted draws from the posterior density. Data are monthly from 1999 to August 2024. The aqua ‘domestic’ bars sum the effects of UK demand, supply, monetary policy, and risk shocks. The pink ‘global’ bars sum the effects of global demand, supply, monetary policy, and risk shocks. The residual bar groups together the effects of the constant, the ‘UK residual’ shock and the deterministic component. See the online appendix for more details.

Not only the source, but the nature of shocks matter. Although the chart only goes back to the late 1990s^{footnote [24]}, it can help test the good luck hypothesis further. Having established that global shocks play a larger role in determining UK inflation over the past two decades, what types of shocks have these been? More specifically, if the high inflation in the 1970s and 80s can be explained by severe oil price shocks, have there been fewer of these shocks since the 90s? From the standpoint of monetary policy institution and challenge, it is important to distinguish between trade-off inducing and non-trade-off inducing shocks. As my former colleague Ben Broadbent pointed out^{footnote [25]}, demand shocks are easier for monetary policymakers to respond to than supply shocks because they do not imply a trade-off between the MPC’s primary inflation remit and its secondary remit of supporting growth and employment.

Chart 5 shows the same model-implied decomposition of UK CPI inflation, this time split into the nature of shocks regarding this inflation-activity trade-off. Through the lens of the model, fluctuations in UK inflation have mainly been driven by domestic and foreign demand-type shocks over time. Given these are non-trade-off inducing shocks, we might say that the job of monetary policy to keep inflation at the 2% target was simply a lot easier during the Great Moderation period – at least up until Brexit, Covid, and Russia.^{footnote [26]} There has been a notable upward contribution of the component labelled “other” (the pink bars) on this chart, which is largely driven by the effects of ‘risk’ shocks. This contribution is most notable, both in its size (in historical context) and timing, from 2016 onwards, reflecting the consequences of the outcome of the Brexit referendum^{footnote [27]}, and subsequent shocks I just mentioned, relating to Covid and Russia’s invasion of Ukraine.

Chart 5: SVAR-implied historical decomposition of CPI inflation

Year-on-year percentage changes

Footnotes

• Source: Brandt and Burr (mimeo).Notes: The chart shows the historical decomposition implied by the pointwise mean across accepted draws from the posterior density. Data are monthly from 1999 to August 2024. The aqua ‘demand’ bars sum the effects of the UK and global demand shocks. The orange ‘supply’ bars sum the effects of the UK and global supply shocks. The purple ‘monetary policy’ bars sum the effects of the UK and global monetary policy shocks. The pink ‘other’ bars sum the effects of the UK and global risk shocks as well as one unidentified shock. See the online appendix for more details.

I might note here that, again from the perspective of this particular model, the finding that inflation has been caused mostly by demand-type shocks applies even to the recent period of high inflation. This may come as a surprise to some given that we saw dramatic supply-side disruptions alongside accelerating global inflation in 2021 and 2022. Keep in mind the substantial contribution of fiscal policy, accounting for 2 percent of GDP, to buffer the consequences of the energy shock to households. While called for, the policy did allow for a transfer of spending power to non-energy goods and services, likely contributing to the inflation persistence observed, particularly in services prices.

This narrative of the last couple of years for the UK matches the findings of Giannone and Primiceri (2024) who show that euro area inflation can be explained largely by demand-type shocks, albeit they find a more even balance between demand and supply forces driving US inflation, as does Shapiro (2024).

In any case, this narrative for the UK in the Great Moderation years is quite different from the confluence of shocks observed over the pre-moderation period. Chart 6 shows a decomposition of UK inflation from a different empirical model beginning in the 1960s.^{footnote [28]} First, the contribution of trend inflation is very large, averaging around 10% over the whole period. This confirms that the inflation trend was nowhere near what we would nowadays consider consistent with price stability (that is, 2%).

Chart 6: Co-integrated VAR decomposition of CPI inflation pre-inflation target

Year-on-year percentage changes

The second thing to note is the contribution of the trade-off inducing supply shocks to the inflation peaks of the early and late 1970s. Aggregate supply shocks were more dominant than demand shocks – evidence in favor of the good luck hypothesis of the Great Moderation years for the UK. This model however also hints at the good policy hypothesis, in that loose monetary policy significantly contributed to the first peak in inflation around 1975 (recall that, at the time, the UK had no widely accepted nominal anchor in place).

As mentioned earlier, ‘good luck’ and ‘good policy’ are importantly intertwined and contribute to fewer policy surprises, a better recognition of the central bank reaction function, and greater credibility. Economic models estimated during the low volatility and low inflation period reflect this stability as the economy runs nearer to long-run equilibrium – at full employment and target inflation When used as part of the policy-making process, these stable models would tend to deliver fewer policy surprises.

When ‘good luck’ runs out, however, and the economic environment has higher volatility and higher inflation, these models are less representative of how the economy responds. Therefore, they will be poorer at guiding policy decisions. Economic relationships that were stable before may be characterized by non-linear characteristics and changes in the monetary policy transmission process. The dynamics of the responses of households, firms, and financial markets to this new environment will dominate the monetary policy horizon, rather than there being just small perturbations around the long-run equilibrium. Central bank policymaking is harder to gauge and to communicate, but the commitment to the target is even more critical under these more volatile circumstances.

… neither good policy, nor good luck, but something else entirely?

There is one other big structural change in the world economy that happened over this period of time, which has nothing to do with either better monetary policymaking or the more manageable nature of economic shocks: The integration of China into global markets and rapid expansion of trade, through technology-enabled integration of supply chains across the globe, and long periods of substantial current account imbalances. Below (Chart 7), I am reproducing a chart from Ben’s speech (Broadbent, 2024) which shows the massive increase in trade as a percentage of global GDP that happened alongside the Great Moderation.

Chart 7: World trade as a percentage of world GDP

Percent of world GDP

Footnotes

• Source: World Bank Development Indicators, Borin and Mancini (2019) as reported in World Development Report (2020) and Antras (2020), and Bank calculations.Notes: World trade is defined as the sum of world exports and imports of goods and services as a share of world GDP in value terms, divided by two as a country’s import is another country’s export.

There is extensive literature on the disinflationary effects of increased trade over the past couple of decades. For the UK, for example, Lewis and Salaheen (2018) estimate that increases in imported goods just from China lowered import price inflation by half a percentage point per year. This alone is significant. But it is likely a lower bound as it reflects only the direct effect of import prices and the effect of increased competition for domestic producers.

Global integration acted as a shock absorber for domestic imbalances. Imbalances that would, in the absence of trade, be reflected either in domestic price pressures or perhaps costly employment effects. Consider Chart 8. It is an update of a chart in Bean (2010) showing current account balances in five large economies. In the two decades before 1980, few countries ran persistent current account deficits or surpluses, in part on account of the discipline of Bretton Woods. However, as globalization took hold, exchange rates started to float, and, importantly, financial markets were deregulated, the world seemingly split up into trend net-importers and trend net-exporters.

Chart 8: Current account balances

Percent of nominal GDP

Footnotes

• Source: IMF, Jorda et al. (2017), and Bank calculations.Notes: As in Bean (2010), series are in five-year moving averages. Data before 1997 are from release 6 of the Macrohistory database (Jorda et al., n.d.), thereafter from the IMF World Economic Outlook (2024a). Observations for 2024 are the nowcast from the October 2024 IMF World Economic Outlook (2024b).

At that time, current account balances switched from mostly trade-driven to mainly capital flows-driven. Since the current account is the flipside of a nation’s capital account, a deficit in one is associated with a surplus in the other. Because the US, and to some extent the UK, were able to attract capital inflows from other countries, a commensurate trade deficit opened up. These divergences in capital flows were enabled by the rapid de-regulation of the financial services industry on both sides of the Atlantic.^{footnote [29]}

However, part of the divergence in current account balances, particularly at the start of the sample, can also be explained by cyclical differences and different monetary-fiscal policy mixes. This is a bit of a blast from the past, but in 1987, right at the first trough in the US deficit in the chart above, I co-authored a Fed paper (Hooper and Mann, 1987) which sought to explain the relatively large US deficit as related to the strong dollar (coming from unleashed capital flows) coupled with a large growth differential vis-à-vis trading partners that yielded a trade imbalance (imports to exceed exports) that was larger and for longer. This was supported by a relatively expansionary fiscal stance alongside tight monetary policy.

At business cycle frequency, more trade volatility and perhaps also more volatility in current account balances may be desirable since buying goods from abroad means that temporary excess demand in one country can be offset by temporary excess supply in another, making both countries better off. Without trade, these demand and supply overhangs must necessarily be equilibrated by domestic adjustment, which often means changes in prices, i.e. inflation in the former and deflation in the latter case.

Imbalances this large and this persistent also tells us something about fundamental societal choices and preferences. For example, the persistent consumption weakness that is the domestic counterpart to the current account surplus of, for example, Germany, should not be interpreted as a decades-long conjunctural slump. Rather, it may be that societies running these surpluses have a different risk aversion, discount factor, and propensity to save than others. Thus, the divergence in current account balances not only reflects substitution across countries but also intertemporal substitution within countries. Crudely, while the American consumer has wanted to consume goods and services now, the German consumer has tended to prefer saving (and thereby deferring consumption to the future). However, these external imbalances have domestic implications including being associated with rising domestic inequalities and external vulnerabilities, which have become the source of new shocks.

Consequences for the outlook and monetary policy strategy

Let us now look forward. Having a better understanding of what drove volatility pre-Great Moderation, and the factors that might have brought about, and sustained the Great Moderation has helped me think about what to expect going forward. There is a lot to learn from economic history, even if shocks don’t tend to repeat themselves in quite the same institutional, macroeconomic, and geopolitical constellation.

The economic consequences of a volatile environment

First, does it even matter if the world is a more, or less, volatile place? A rhetorical question to which the answer is yes, but at different levels of aggregation. First, at the micro-level, yes, because uncertainty about the future affects household spending behavior as well as firms’ investment decisions. For example, we know that uncertainty reduces investment, consumption, and employment (Bloom, 2014; Jens, 2017; Coibion et al., 2024) as it increases the so-called ‘option value of waiting’ (Dixit and Pindyck, 1994), with firms optimally deferring decisions until the true state of the world is revealed.^{footnote [30]}

Second, and more macro, increased uncertainty about the future critically affects both sides of the market for capital: On one side, firms defer investment so that there is less demand for productive capital, while on the other, people defer consumption, thereby increasing the supply of savings. Both shifts lead to more abundant savings relative to investments, which lowers the real risk-free rate necessary to bring the two into equilibrium. Higher uncertainty may mean that r* falls, all other things being equal.^{footnote [31]}

This is a point about volatility in real variables, causing a fall in real equilibrium interest rates.^{footnote [32]} However, what most people face are nominal variables and nominal interest rates: they earn nominal wages and pay nominal prices. It appears that nominal volatility has especially pernicious effects on the macroeconomy, given well-known behavioral biases associated with nominal price and wage setting. Because prices are more rigid downwards than upwards, inflation does not follow a symmetric process even if shocks are symmetric.^{footnote [33]}

Look again at the chart of the long view of international inflation since the 1960s (Chart 2). Even relative to some slow-moving trend, inflation tends to spike up much more often and sharply than it spikes down. For the three regions in the chart, the Global Financial Crisis was the only moment in the past 65 years that prices actually fell for a little bit. I worry that, if we do end up with a more volatile economy, that it will be an economy with an inflationary bias. Indeed, Ascari and Sbordone (2014) show how trend inflation and volatility go hand in hand.

Such an economy would be one with higher nominal rates. On the one hand, central banks would need to more often lean more strongly against inflationary episodes, in order to stabilize expected inflation at their target. In addition, investors will demand a risk premium before locking away cash in nominal contracts (see also Mann, 2023c).

In this view, average nominal interest rates, nominal r* if you will, may well be higher in a more volatile world. I have previously expressed my skepticism of many of the workhorse models in macroeconomics which tend to abstract from non-linear behaviors and higher moment considerations (Mann, 2023a). These models maintain a separation between real and nominal trends which they have inherited from their Real Business Cycle ancestors. This separation is largely artificial; nominal trends and behaviors matter a lot in the ‘real’ world.

Sources of volatility in the future

What do I have in mind that could yield higher volatility going forward? I see it as likely that many drivers of the Great Moderation that I have described so far may be unwinding. That, in combination with a new set of risks means the possibility of higher volatility, not just in the UK, but globally.^{footnote [34]} While there are of course many risks, there always are, let me spell out several in a bit more detail.

Climate change. First, consider the effects of climate change mitigation policies and physical risks shocks. I discussed the former in detail in a speech last year (see Mann, 2023d). The introduction of various uncoordinated climate mitigation policies may introduce volatility. Price-based instruments such as carbon taxes create volatility in output, and quantity-based instruments such as an ETS create price volatility. In addition, there is added uncertainty about future changes to policy stringency that may further accentuate macroeconomic volatility.

In the case of climate in particular, there is also an intertemporal externality associated with policy uncertainty and the decisions needed to get to net zero: For an individual firm, policy uncertainty increases the option value of waiting. So investments are not undertaken, and emissions continue unabated. But, for the environment, the longer we wait, the more costly the investments needed to limit global warming, and the more damage that needs to be mitigated (NGFS, 2024).

Global trade fragmentation. As explained above, the increase in world trade overall has made us more resilient in the face of domestic imbalances. But, at the same time, it also made us more exposed to global shocks, because they propagate to the UK economy through spillovers via the exchange rate, imports and exports, as well as financial markets. Covid-related supply chain concerns and Russia’s invasion of Ukraine cemented the view that global integration exposed the domestic economy to too much risk. The Russian energy shock was so large that it prompted many countries to vow to, on the one hand, diversify where they import their energy from, and on the other, to reduce their dependency on trade partners to improve energy security.

Not only does global fragmentation likely put upward pressure on costs and prices, but monetary policy decisions will also need to consider the channel of reduced productivity growth, which creates greater vulnerability to shocks, regardless of the source, relative to a situation where trend growth is higher. In a report I authored while I was chief economist at Citibank (Mann, 2019), I argued the benefits of globalization and trade openness, which now risk being undone, reducing productivity growth. This productivity slowdown observed through the lens of generational cohorts reveals a less advantageous starting point for each successive generation’s living standards and a slower increase in living standards for that generation as it ages over time. Considering volatility by itself, Silvana Tenreyro (2021) shows that global integration, through diversification, reduces the effects of domestic shocks.

These concerns are not just of interest to monetary policy but also for financial stability. For example, Gilhooly et al. (2018) highlight how the UK economy is also exposed to China through strong financial linkages, which, in an adverse scenario may act as shock amplifiers rather than shock absorbers.

Furthermore, uncertainty about trade policy in itself may have damaging economic effects and increase volatility.^{footnote [35]} The latest political developments across the Atlantic have not made a disorderly trade scenario less likely, which would have consequences for output and inflation in the UK.

Financial Market volatility, or not. Deregulation of domestic and international capital markets in the 1980s enabled countries to run current account imbalances that, at the time, helped moderate inflation and output volatility. This environment ended with the Global Financial Crisis, one of the largest punctuations during the Great Moderation period. Looking forward, technology-enabled evolution and policy-induced changes in financial institutions, in payments mechanisms, and in digital currencies, including CBDCs, are part of this picture.^{footnote [36]} Will this evolution of financial markets, indeed of money itself, similarly lead to a moderation of volatility or not, or for a time moderation, and then not?

Policy-induced volatility and spillovers. Policies to address climate change, support domestic industries as trade is reoriented, and to counter geopolitical risks all have important fiscal elements. Countries and regions may use different mixes of policy tools, as well as differ in the overall deficit envelope. How effective these policies may be at catalyzing private activities will matter for the sustainability of the fiscal efforts, the potential productivity gains, and possible inflation and activity outcomes. All of these issues will affect the appropriate monetary policy stance. The combinations of fiscal and monetary policy mixes that differ across countries likely will yield cross-border spillovers and financial market volatility, contributing to inflation volatility which the central banks will need to lean against.

Monetary policy strategy implications

Turning to the strategy implications, how might a monetary policymaker best respond to a situation of higher macroeconomic volatility? To be clear, perfect macroeconomic stability is not a realistic target for monetary policymakers: Shocks happen, and even optimal monetary policy does not imply the ability to foresee unanticipated shocks. Nevertheless, good monetary policy does require preparing for the existence of these shocks, being able to observe the shocks when they occur, and having an understanding of how policy should respond and transmit through financial markets and to the real economy under different scenarios. Identifying shocks when they occur, and responding so as to re-stabilize the economy are decisions often made under considerable uncertainty. Observing a shock and knowing how it might play out and transmit to the economy are two different things – we only have historical experience and economic models to guide us.

Recent staff work develops a weekly asset price SVAR to identify structural shocks that explain movements in certain asset prices – providing a higher frequency understanding of drivers than is offered by a typical macroeconomic model. Applying this work to the current conjuncture, Chart 9 shows a decomposition of the UK 3-year inflation swap rate into domestic and global drivers. Understanding that it is global factors that have pushed down on the inflation swap rate in the second half of the year, but domestic factors have consistently pushed up over the whole year, suggests a more guarded view that the risks of inflation persistence will dissipate sufficiently to reach the 2% target sustainably in the medium term.

Chart 9: Weekly SVAR decomposition of change in 3-year inflation swap rate

Cumulative basis point change

Footnotes

• Source: Bloomberg Finance L.P., Tradeweb, LSEG, ICE BofAML, and Bank calculations.
• Notes: The chart shows the historical decomposition since January 2024 of the cumulative change in the UK 3y inflation-linked swap implied by a weekly asset price SVAR. Estimation of the model relies on weekly data from January 2005 to October 2024. The model consists of UK domestic and international asset prices and relies on zero and sign restrictions to identify domestic and non-domestic shocks. The aqua 'domestic' bars sum the contributions of UK aggregate demand, aggregate supply, monetary policy, and uncertainty shocks. The pink 'global' bars depict the contribution of non-domestic shocks, i.e., global demand, global supply, risk aversion and US monetary policy shocks. The residual bar represents the unexplained variation from the SVAR.

This is one example of a way in which monetary policymakers could identify shocks nearly in real time.^{footnote [37]}

Speak to any policymaker, and they will tell you that policy is never set under certainty. And often they might argue that uncertainty is unusually high. It would be problematic if we concluded we would need to wait until reaching this point of certainty before taking monetary policy action. What does optimal policymaking look like under uncertainty? The classic references have been Brainard (1967) and Woodford (2003) who argue that gradualism is the preferrable approach to monetary policymaking. They argue that minimizing large changes in the policy rate promotes macroeconomic stability. This implies a need for policy to be quite forward-looking, so as to avoid being caught by surprise which would require large policy rate changes. Economic agents likewise need to be forward-looking. With shocks, spillovers, and uncertainties, this combination of forward-lookingness is not always prevalent.

It is also important to recognise that increased macroeconomic uncertainty tends to imply increased financial market uncertainty (Chiu et al., 2016), which may be exacerbated by adverse cross-country spillovers. This has the potential to affect the transmission of monetary policy through markets as it might blur the signal which policymakers wish to send.^{footnote [38]} And, in turn, it blurs any signal that policymakers may get from financial markets about the outlook or the perception of their own stance. In such a world, I believe monetary policy actions and communications must be more forceful to cut through the noise.

What are the implications of uncertainties for my decision-making? Staff work on inflation uncertainties has importantly informed my view that an activist strategy is appropriate. The research considers various kinds of inflation uncertainties. If the shock is truly persistent, but is misperceived as transitory, the policymaker initially under-reacts, yielding an inflation overshoot both larger and more persistent than under full information. If there is uncertainty about the degree of inflation persistence, it is better to assume a high degree because the costs of making a mistake if the true inflation process is more persistent are larger than if the true inflation process is less persistent.

If there is a risk of more upside persistence to inflation, in other words, the mass in the right tail is more than the left tail, then even if the upside risk is not realized, a tighter monetary stance is warranted relative to the case where there is no such asymmetric tail risk. As inflation was beginning to take off, the activist policy strategy would get ahead of these upward biases to inflation by front-loading larger policy moves to forestall the embedding of inflation (Mann, 2022a). Therefore, I judge that the optimal strategy for a policymaker under the uncertainties likely to be evident going forward, of increased volatility that is upward-inflation-biased, is an activist one, rather than the gradualist approach to policymaking. Indeed, my votes in 2022 were more activist than that of the collective MPC.

Is there more to the activist strategy in the future world of greater inflation volatility? In addition to the inflation uncertainties already discussed, the terminal rate, r*, needs to be considered in order to estimate the degree of restrictiveness. As discussed above, inflation volatility is more likely to result in a higher nominal r* as the central bank leans against the prevalence of shocks. This higher nominal r* implies a less restrictive stance, all else equal. Therefore, the activist policymaker needs to take this into account and maintain policy rate discipline.

But what about right now, when inflation is decelerating? What is an activist strategy now?

The name activist is a bit of a misnomer since it implies a period of ‘wait-and-see’ if inflation persistence has been purged, to then act fast and forcefully. Staff work shows that fast and forceful can have immediate effects on inflation expectations and the price-setting prospects of firms – the key ingredients to inflation developments (Di Pace et al., 2024). In the face of uncertainties about the outlook for inflation and output, waiting buys time to learn more about developments, to make a better assessment of whether the inflation risk has subsided sufficiently to justify changing the policy stance. In the current context, an activist stance holds the policy rate firmly until sufficient evidence on diminished inflation persistence is revealed; and then to move forcefully.

The views expressed in this speech are not necessarily those of the Bank of England or the Monetary Policy Committee.

Acknowledgments

I would like to thank, in particular, Lennart Brandt and Natalie Burr for their help in the preparation of this speech, as well as Andrew Bailey, Oliver Bush, Jenny Chan, Rodrigo Guimarães, Swasti Gupta, Ed Hall, Clare Lombardelli, Josh Martin, Mauricio Salgado Moreno, Waris Panjwani, Alan Taylor, Ryland Thomas for their comments and help with data and analysis.

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