Moreover, the relatively close co-movement between finished manufactured goods import prices and consumer goods prices (excluding energy and food) over the past two years is suggestive of relatively high and rapid pass-through (Chart 2). The faster adjustment of prices relative to that implied by the evidence from the Great Stability may partly reflect the fact that much of that evidence for the UK is based on the  2  For example, see Section 4 and the box on pages 48-49 of the August 2010 Inflation Report, Fisher (2010) and Sentance (2009). 3  Much of the recent analysis of exchange rate pass-through is based on evidence taken from the Great Stability period (see for example Campa and Goldberg (2006) and Ihrig, Marazzi and Rothenberg (2006)). The results from these studies pick up the average lag structure of the past, and are sensitive to the window in which exchange rate effects are identified. It may be that the lag structure following sterling’s depreciation was quicker. To the extent that businesses adjusted more quickly, pass-through in the current period might appear larger than suggested by the econometric techniques used in previous studies, when in fact the adjustment was only faster. BIS Review 122/2010  3  behaviour of prices following sterling’s appreciation in 1996. It is quite possible that those businesses whose margins were squeezed following the recent exchange rate depreciation responded more quickly than they did to the increase in margins associated with the mid1990s appreciation.
The third factor emphasised by this type of pricing model is the mark-up over costs included in the final selling price which governs the return firms make on capital. As I will discuss later, there is some evidence to suggest that movements in this mark-up have been different in this recession than in previous ones. The final set of factors determining pricing decisions are expectations of future costs and prices. Most companies change prices infrequently and as such their pricing decisions today are based on expectations about how their costs and their competitors’ prices are likely to vary in the future. Similarly, pay awards are likely to be affected by firms’ and employees’ expectations of future inflation. I will use this broad framework to consider why inflation has been above the 2% target for much of the past four years and why inflation was higher than expected for much of this period. Price level shocks It is not difficult to find factors that have pushed up inflation over the past few years. The economy has been hit by a series of large price level shocks – to oil and other commodity prices, to VAT and to the sterling exchange rate – which have raised companies’ costs and  1  The key intuition of this model is based on work such as that by Marshall (1920), Chamberlin (1933), Spence (1976) and Salop (1979), among many others who contributed to this now well established literature. 2  BIS Review 122/2010  put upward pressure on prices.