Indeed, it is the credibility of our commitment to price stability that has enabled the Bank to cut interest rates and to inject money so aggressively in order to support nominal demand in the wake of the credit crisis. If, as in the bad old days, the monetary authority lacked credibility, I believe that the stimulus would have had to be smaller and the downturn would, in consequence, have been greater. That underlines the risks of tinkering with central bankers’ inflation targets, as some commentators have seemed to suggest. When, unusually, we face any kind of choice in the path of demand and activity consistent with maintaining price stability, we obviously err towards the stronger path. As I have described, that is a factor today when some businesses have suspended but not yet scrapped capacity. In aggressively stimulating demand in order to absorb slack, we aim to keep inflation in line with the target over the medium term and also to reduce the extent to which the economy’s productive capacity is wasted. Due to the endogeneity of firms’ supply capacity, that is going to call for some difficult judgments in the quarters ahead about the evolution of slack in the economy and about pricing pressures. Another element of stability – in the financial system – is plainly necessary to maintain stability in demand, output and employment. As many researchers have shown, recessions associated with financial crises have tended to be longer and deeper. 14 That is the backdrop to the debate on reforming the financial system.
To achieve the 2% inflation target over the medium term but at the cost of an avoidable depletion of the economy’s supply capacity would not be congruent with the MPC’s Remit, which includes supporting growth and employment in so far as that is consistent with the overriding goal of price stability. I was glad that the “effective supply” way of thinking about this was reflected in our latest Inflation Report. But I would readily concede that we must not lose sight of the potential “speed limit” effects that featured in our November Report. Given the need for some rebalancing in the pattern of demand and activity, and the likely lags in firms bringing even suspended capacity back on-line, bottlenecks are a distinct possibility. We will need to be especially alert to messages from the Bank’s Agents, to survey evidence, and to data on productivity, wages and prices for any sign of inflationary pressures. Volatility of inflation, and inflation expectations The Committee’s strategy has warranted maintaining the very substantial monetary stimulus notwithstanding the marked pick-up in inflation over recent months. As the Governor explained at our press conference a fortnight ago, we think that the recent rise in inflation is accounted for mainly by the increase in petrol prices, the restoration of VAT to 17.5%, and lagged effects of sterling’s substantial depreciation. But we can’t be, and aren’t, comfortable about it. Not least because the country has to trust us that these will be temporary disturbances.