Pay pressures in the labour market are muted, reflecting in part the need of employers to adopt a tough stance in wage bargaining when faced by such large increases in other input costs. Companies facing higher costs for energy, raw materials and other inputs, have been willing to offer only moderate wage increases in  BIS Review 52/2006  3  order to minimise the squeeze on their profit margins. The rapid rise in input prices and the muted degree of pay pressures are not independent of each other. Inflation expectations – whether measured by household surveys or implicit in government bond yields – have moved up during the course of this year. Although not of serious concern as yet, the MPC will monitor inflation expectations carefully. Inflation itself remains volatile as increases in oil and natural gas prices pass through to household bills. Those increases will dampen the growth of real household disposable incomes and moderate consumer spending. So the economic outlook is far from certain. In these circumstances the Monetary Policy Committee must examine carefully all information, learn and, if necessary, revise its judgements, and question all received wisdom. In other words, it must be enlightened. The Scottish Enlightenment, it is generally agreed, began and ended in the 18th century. Our present framework for monetary policy is of more recent vintage.
Focussing too much on short-run movements in demand may lead it to misjudge the outlook for inflation. It is not possible to form a view about the extent of spare capacity in the economy – the so-called output gap – without explicit judgements on how much the economy is capable of producing. But it is really quite difficult to disentangle movements in the output gap from changes in supply capacity. One economist’s output gap is another economist’s change in supply potential. That issue has been central to the deliberations of the Monetary Policy Committee in recent months. The current outlook for inflation – and hence interest rates – depends not only on the prospects for demand but also upon whether the changes to the supply capacity of the economy that we observed in the past will persist or reverse. Over the past year or so, a degree of uncertainty has entered the economic landscape on both the supply and demand side. So what is causing this uncertainty? On the supply side, inflows of migrant workers from the new member countries of the EU remain high. That may or may not continue, and we cannot be sure that migrants would stay in the UK if the labour market were to turn down. And it is also unclear whether businesses will be able to recruit staff as easily as in the past when, as the prices of imported goods and services fell, the real value of take-home pay rose without higher wage settlements.