INFLATION, INFLATION, INFLATION

Thank you for the invitation to speak this evening. I studied for my undergraduate degree in economics at what was then University College Cardiff in the mid 1980s. I had three wonderful years in Cardiff and it is a huge pleasure to come back tonight and to see so many familiar faces. Although I hope some of those familiar faces will be kinder to my speech tonight than they were with my essays back then.

The theme of my talk tonight is inflation.

I hope that you won’t find that too disappointing. I fear that some of you were looking forward to a talk on more exciting topics like the financial crisis, the new responsibilities that have been granted to the Bank, the speculation concerning a double dip.

But I make no apology for focussing on inflation. One of the cornerstones of our economy’s stable and consistent growth in the 15 years or so prior to the financial crisis was the period of low and stable inflation that was achieved then. And our future prosperity will depend on our maintaining an environment of low and stable inflation.

One of the most worrying comments I have heard in recent months came at a lunch of senior businessmen I attended. One of the diners suggested that the UK was returning to its old ways “of depreciating the exchange rate and inflating its way out of trouble.” Soon after, a City circular asked “is the MPC turning a blind eye to inflation?”

This is dangerous talk. The evils of inflation are well known. The high and volatile rates of inflation of the 1970s and 80s stunted our economic performance. Companies and households were unable to budget and plan efficiently. Resources were misallocated. Long-term contracts were avoided. The value of hard-earned savings was eroded.

This dangerous talk has perhaps been partly fuelled by the behaviour of inflation in recent years. CPI inflation has averaged close to 3% over the past four years, significantly higher than the 2% target and for the most part higher than the MPC anticipated. CPI inflation has been above target for 41 out of the past 50 months. Lest we forget, this is a long, long way from the high and volatile inflation of the 1970s and 80s. Even so, it is perhaps understandable that some may have started to question the commitment or competence of the Monetary Policy Committee. Has the MPC gone soft on inflation? Is this a conspiracy with the Government to deflate away some of its debt?

The answer to both these questions is emphatically “No”. The MPC remains as committed as ever to meeting the inflation target. It is our job to achieve the target and we are accountable to Parliament for doing so. To borrow from a phrase of a previous Prime Minister, ask me my three main priorities for monetary policy and I will tell you: inflation, inflation, inflation. Maintaining low and stable inflation is the best contribution that monetary policy can make to the long-term health and prosperity of our economy.

But I recognise that reassuring words and good intentions are not enough. We need to understand better the factors causing inflation to be above target. And we need to learn from the upside surprises in inflation we have experienced recently. That is the topic of tonight’s talk. I will argue that it is not difficult to explain the past strength of inflation. In fact there is a surplus of explanations. But there are important lessons to learn from the recent behaviour of inflation.

And I will explain to you why – despite inflation being above target and expected to remain so until the end of next year and monetary policy being at unprecedented loose levels – the MPC has not gone soft on inflation.

What determines inflation?

To help structure the discussion, I want to frame my comments in terms of a simple model of pricing behaviour, in which companies are assumed to set prices as a mark-up over marginal costs. The precise details of the model are not important for tonight. Many of the mechanisms and channels that I will discuss are embodied within standard pricing models.1 More importantly, my experience of speaking to businesses since the financial crisis began suggests that this type of framework captures the key factors that have been important in determining their
pricing decisions. In particular, this type of pricing model emphasises the role of four types of factors.

For the full speech see: http://www.bankofengland.co.uk/publications/speeches/2010/speech448.pdf