This kind of effect was reflected in the MPC’s judgment in the February 2010 Inflation Report that effective supply capacity might at the moment be reduced below  9  Nelson and Nikolov (2005) suggest that in the 1980s the average real-time output gap measure was over 5 percentage points below the average final measure, of which more than 4 percentage points was due to revisions to the level of output. 10  Discussed in detail in Neiss and Nelson (2005). 11  Greenslade, J and Parker, M (2008). 4  BIS Review 27/2010  the estimate which would result from simply looking at trends in capital, labour and total factor productivity. The MPC is prompted to look at this type of explanation against the background that at present CPI inflation (adjusted for estimates of the impact of the VAT change and of higher oil prices) is rather higher than might have been expected given the sharp fall in output. But the possible explanations discussed above suggest that the output gap has recently not been as large as simple models might suggest, and therefore higher CPI is less surprising. One reason for thinking that this effect may be pertinent is that indicators of spare capacity (Chart 3 shows one example) have fallen by less in response to the sharp fall in output than might be expected. But it is also probably true that these surveys are more difficult than usual to interpret in the wake of very large shocks to demand.
The reasons for this period of relatively high inflation are related in large part to external pressures from past exchange rate depreciation (and the exchange rate has recently depreciated further) and the rise in the oil price over the past year. Some domestic inflationary pressures remain low, as indicated by the present low rate of increase in wages (the latest data for average weekly earnings showed an annual increase of just 0.8% for total pay in the three months to December 2009). So looking beyond 2010, the latest inflation projection suggested there that inflation could be a little below target at the two-year horizon. However, the present above-target inflation background suggests little cause for anxiety about inflation expectations becoming deanchored on the downside, if the MPC were to suggest it might take a little longer to move the underlying inflation trend back to target. Indeed, that might be one way to respond to the balance of risks the MPC faces, with inflation uncomfortably high in the short term, but medium-term prospects still likely to be on the downside. There are other arguments on both sides. The remit for the MPC invites us, subject to achieving the inflation target, to consider the Government’s polices for growth and employment. In the present context, a strong argument for continuing to focus on the twoyear horizon is that would encourage policy to aim at a rate of growth in the short-term which would reduce the scale of excess capacity in the economy as fast as possible.