Since all other demand components were falling, the manufacturing sector was able to attract resources and expand. We have not had a current account deficit since 1993. Why 2 per cent inflation and a floating exchange rate? That two per cent is the optimal inflation target has no scientific basis. However, this level gives a reasonable trade-off between the negative consequences of high inflation and the problems entailed by deflation. Furthermore, two per cent is a common target internationally. It is necessary, you see, to have a certain margin from zero inflation if price and wage formation are to work well. Separate prices and wages have to be able to grow at different rates if it is to be possible to allocate resources such as labour to their correct use. Since it is difficult to cut nominal wages, some inflation creates the possibility for relative changes in wages without having to reduce the nominal level for any group. The scope for wage increases given the inflation target is around 4 per cent. (2 per cent + 2 per cent: Inflation plus productivity growth, at a given profit share. )1 This holds if we, like the National Institute of Economic Research, assume that average productivity growth is around 2 per cent for the whole economy in the long term. If one occupational group gets 5 per cent in order to attract labour, another group has to get less than the average increase.
History demonstrates that shifts in the quantity of money have often been driven – or at least accompanied – by shifts in the demand for deposits (i.e. what the private sector would like to hold for a given level of spending). Following the financial liberalisation earlier that decade, banks began during the 1980s to pay interest on standard deposit accounts. This increased their attractiveness, relative to other “stores of wealth” – they were not the precursor to higher spending and inflation – and broad growth remained stubbornly high even as inflation declined sharply (at least until the boom at the end of the decade). For similar reasons broad money growth was extremely strong throughout the first fifteen years of inflation targeting (1992-2007). Nor is there a tight correspondence between “narrow” and “broad” money. QE involves the creation of central bank reserves to buy financial assets (usually government debt). So in the decade or so that passed between the first use of the policy in 2009 and the onset of the pandemic, reserves grew extremely rapidly. Yet broad money growth was significantly slower than it had been before the crisis (Chart 1). And, in both periods, average inflation was close to 2% (Chart 2). Page 4  Chart 1: Reserve creation neither necessary nor sufficient for strong growth of broad money  Sources: ONS, Bank of England and Bank calculations. Unless stated otherwise “broad money” refers to M4 excluding intermediate other financial corporations (M4ex).