2  For more analysis of the impact of quantitative easing, see: David Miles, “Interpreting Monetary Policy”, speech at Imperial College Business School, London, 25 February 2010; and Spencer Dale, “QE One Year On”, speech at CIMF/MMF Conference, Cambridge, 12 March 2010. BIS Review 31/2010  3  That brings me naturally to inflation, the MPC’s mandated target. One might expect that, after such a sharp downturn, inflation would have dropped back. Indeed, inflation had fallen as low as 1.1% last September. Since then, it has moved up sharply, reaching 3.5% in January and triggering an open letter of explanation from the Governor to the Chancellor. That volatility in inflation can be explained in terms of a variety of factors impacting on the price level: the restoration of the standard rate of VAT to 17.5%; recent movements in the oil price and a year earlier; and the pass-through into consumer prices of the higher import prices associated with the depreciation in sterling. When setting monetary policy, the MPC looks through effects that can be expected to affect inflation only transitorily, to the underlying determinants of inflation in the medium term: inflation expectations; and the margin of slack in the economy. Despite recent volatility in actual inflation, inflation expectations, according to a variety of measures, have remained stable and reasonably well anchored at levels consistent with the target. There is, however, considerable uncertainty about the extent of the downward pressure on inflation from economic slack.
With output some 10% lower than it would have been if pre-crisis growth rates had been maintained, it would appear that the margin of spare capacity ought to be large. But the evidence from past sharp downturns after banking crises is that they can have a significant impact on the economy’s supply potential (Chart 8). Downturns typically lead to less investment, more capital scrapping, fewer business start-ups and more business closures and a restriction in the availability of credit is likely to aggravate these effects. Moreover, lower employment can lead to skills atrophying and the long-term unemployed becoming disconnected from the labour market. Business investment has fallen sharply in this recession – down more than a quarter from its peak – though only part of that is likely to reflect a restriction in the availability of credit. Heightened uncertainty is also likely to have played a part. But against that, both business closures and, as noted earlier, unemployment have risen less than feared. So the overall impact of the downturn on the present and future supply potential of the economy is rather uncertain. In addition, in present circumstances the extent of the downward pressure on inflation from spare capacity is also uncertain. Once one allows for the effect of transient factors such as the restoration of the VAT rate, oil price movements and the likely impact of sterling’s depreciation, underlying inflation has been surprisingly resilient. That could be because the impairment of effective supply as a result of the credit crunch is large.