There are three elements which appear to be underpinning these concerns about the sustainability of growth in the current economic climate: the prospects for the global economy; the prospective impact of the government’s fiscal tightening; and the legacy of the financial crisis. I will discuss these three issues in turn before coming back to the crucial issue of how the Bank of England’s monetary policy can best support the recovery. The global economic outlook A serious setback for the global economy would have major repercussions for the growth of the UK economy. Our economy has a very international focus, and exports, international business activity and the financial sector all play a part in creating strong linkages from the UK to other major economies elsewhere in the world. The sharp drop in business and financial sentiment across international markets in late 2008 and early 2009 – and the ensuing downturn in the global economy – played a major part in tipping the UK into recession two years ago. Similarly, the rebound in the global economy has helped to support our recovery over the last year or so. However, a serious downturn in global growth does not seem very likely at the moment. According to the IMF, global growth this year is now projected to be nearly 5%, compared to a projected growth rate of less than 2% just eighteen months ago.
As Chart 11 shows, we have seen two major spikes in CPI inflation within the last two years. And it is possible that another one is in prospect when higher VAT comes into effect early next year, particularly if this is accompanied by a continuation of the recent surge in energy and commodity prices. These repeated episodes risk eroding confidence that UK policymakers remain committed to low and stable inflation, with a knock-on effect on inflation expectations in financial markets, among the business community and the public which could be self-fulfilling. In the depth of the recession in the first half of last year, we could be fairly relaxed about upward pressures on inflation. At that time, the MPC was worried about the opposite trend – a lurch into deflation with prices and wages on a downward spiral. But these deflationary fears have not been realised. Instead, inflation has run above the target and wage freezes introduced to help businesses weather the storm of the recession are coming to an end. The current period of above-target inflation risks being prolonged by monetary policy which is too lax – creating a climate in which higher inflation is not just the product of one-off shocks but becomes more deeply ingrained. 12  BIS Review 134/2010  The economy is now recovering at home and abroad. The world economy is growing above its pre-crisis trend, and domestic spending in money terms is also following the same pattern, as Chart 12 shows.