The precise details of the model are not important for tonight. Many of the mechanisms and channels that I will discuss are embodied within standard pricing models. 1 More importantly, my experience of speaking to businesses since the financial crisis began suggests that this type of framework captures the key factors that have been important in determining their pricing decisions. In particular, this type of pricing model emphasises the role of four types of factors. First, the marginal cost of producing an additional unit of output, which is likely to depend on the degree of spare capacity. Spare capacity within firms – since it tends to be cheaper for a company to increase output if some of its employees and capital are not fully utilised. And spare capacity in the wider economy – as slack in the labour market will tend to limit wage growth and thus the cost pressures faced by companies. But many companies face other cost pressures that are not related to their own capacity constraints or the ease with which they can hire staff. These “other” costs are the second factor. Some of these costs relate to inputs that are imported, such as energy and other commodities, and so depend on movements in world prices and in the sterling exchange rate. Others stem from domestic factors, including – importantly in the current context – changes in indirect taxes.
8  See the box on page 5 of the July 2010 Agents’ summary of business conditions, available at: http://www.bankofengland.co.uk/publications/agentssummary/agsum10jul.pdf  BIS Review 122/2010  5  But it may also reflect the nature of this recession. Speak to almost any businessperson and they will tell you the same story: to be successful, businesses need healthy cash flow. Cash is king. That has always been the case. But one consequence of the financial crisis – as the availability of bank financed tightened and trade credit dried up – is that the importance placed on maintaining cash flows increased. Companies were less able to trade-off lower selling prices today for future gains in market share. 9 Inflation expectations The final factor emphasised by the pricing model is inflation expectations. The importance of inflation expectations is well understood. If wage and price setters expect the MPC to keep inflation close to target for much of the time, this will be reflected in their behaviour which, in turn, will help keep inflation close to target. Successful policy and anchored inflation expectations are self-reinforcing. A significant risk associated with the recent period of above-target inflation is that it causes inflation expectations to become less well anchored. The dangerous talk may start to be believed. If so, temporary deviations in inflation would tend to be given greater weight in wage and price setting and so become more persistent. And the task of monetary policy would become substantially harder.