Although this remains a significant risk, my reading of the available evidence to date is that inflation expectations remain relatively well anchored. Measures of households’ short-term expectations have picked up over the past year or so, but so have the MPC’s projections for nearterm inflation. Indeed, the MPC’s own revisions to its central inflation projection over the past year have been similar to that implied by a majority of survey measures (Chart 3). And measures of households’ medium-term inflation expectations have remained broadly stable, as have expectations of professional forecasters. Indeed, the surprising strength in inflation during the recession may partly stem from inflation expectations being more firmly anchored than in the past, so helping to offset the downward pressure from spare capacity. This may reflect the different role played by monetary policy in this recession from that in the 1980s and 1990s. In those earlier recessions, policy was designed to reduce trend inflation. As such, expectations about future policy and the emerging spare capacity reinforced each other in bearing down on prices. In contrast, the aim of monetary policy during this recession has been to work against the downward pressure on inflation from excess capacity in order to avoid a prolonged period of belowtarget inflation. Where does all this leave us? To my mind, there is no great puzzle or mystery surrounding the period of above-target inflation seen over the past few years.
Output fell precipitously through the second half of 2008 and into 2009 and, despite the recovery in recent quarters, the level of output remains around 10% below that implied by a continuation of its pre-recession trend. The precise degree of spare capacity is difficult to judge since it depends on the extent to which the recession damaged the supply potential of our economy. 4 Some of the channels through which recessions in the past have impeded supply growth appear, thus far at least, to have been less damaging than we initially feared. Despite a larger fall in output, the fall in employment, although substantial, has been less than in past recessions. Likewise, the pickup in company liquidations has been relatively muted. It is likely that the financial crisis and the reduced availability of credit have affected supply in other ways, such as making it harder for smaller or more entrepreneurial companies to raise funds for investment or expansion. But even so, demand has probably weakened by substantially more than potential supply, implying a large degree of slack both in the labour market and within companies. Consider each in turn. Slack in the labour market has contributed to the muted growth in earnings seen over the past 18 months or so. Annual private sector earnings growth has averaged a little below 1 1/2 % since the start of the recession, around a third of its rate in the five preceding years.