Economists at the Bank of England and members of the Monetary Policy Committee spend a huge amount of time poring over the details of our current macroeconomic position. There is a danger in all this. The danger is a version of not ‘seeing the wood for the trees’. By focusing in great detail about what you see as the most likely scenario for the UK economy, you begin to think that something similar is the only possible future, and therefore give too little weight to the risks that this scenario is seriously wrong. That is the only way I can explain to myself why the MPC have not yet cut interest rates below 0.5%
The Bank’s central projection is that current deflation is a temporary phenomenon. We all know about oil prices, but this projection also involves a view that core inflation will rise from its current level of 0.8%. Today’s low core inflation may have a lot to do with an appreciation of sterling, which should be temporary. In addition actual deflation means that real wages have begun to rise, which should provide a boost to consumption. This could be enough to offset the impact of any renewed austerity, the impact of sterling’s recent appreciation on the demand for UK produced goods, and any delays in investment caused by the possibility of the UK leaving the EU. I could be convinced that this is the most likely outcome, and that inflation will be back at 2% within two years.
But good policy is not about just focusing on the most likely outcome. It is also about allowing for risks. So step back from the trees and just look at the wood. The most basic thing we know about the UK economy is that output is now something like 15% below where it should be if pre-recession trends had continued. For the UK that pre-recession trend had been remarkably stable. There may be reasons why the last recession should be so different from all other pre-war recessions, but we all know the dangers of convincing ourselves that this time is different. So it is possible that the scope for additional expansion is large. This is real uncertainty, but it is also one sided uncertainty. No one is seriously suggesting the economy is running at 5% above trend, let alone 15%!
Of course we get a rather different picture if we look at employment or unemployment. That is because productivity has stalled since the recession. Again quite unprecedented, and somewhat unbelievable if we are thinking about technical progress - have firms collectively thought of no ways that their production processes could be improved since 2009? Productivity growth in other countries has not been great, but are UK firms (some of which are multinational) incapable of learning from the improvements that have been made by others? We have yet to find a convincing explanation for this ‘productivity puzzle’. There is a serious possibility that, due to falling real wages, firms have simply put off making labour productivity improvements for the moment, but such improvements would come quickly if demand picked up enough (and labour became scarce). Again the risks here seem one-sided.
So there are perfectly sensible reasons to believe that the negative output gap might be much larger than currently estimated. There is no offsetting reasons to believe the output gap is large and positive. If the negative output gap is much larger than currently estimated, the social losses being currently made are huge, even if we forget about the deflation dangers ahead.
One final point. Andy Haldane has published some Bank model simulations which suggest that cutting interest rates now would be optimal, assuming that the Bank’s central projection is correct. So even if we ignore everything above about one sided risks, there is a clear case for cutting rates now. 
In these circumstances, the obvious thing to do, as well as the cautious and prudent thing to do, is to cut rates now to cover for the possibility that the output gap is actually much larger than estimated and inflation will therefore not return to target as hoped. The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2% target. If it is not done, there is a non-trivial probability that in 3 years time we will all be asking why on earth the MPC were so complacent.
 I’m not sure if this optimisation exercise takes account of the point made here by Brad DeLong, which is that the existence of the lower bound means that you want to skew policy to avoid hitting that lower bound in the future. This is a rather different asymmetry to the one I explore in this post, but it also points to cutting UK rates now.