In particular, there were three episodes between the mid-1970s and early 1990s, when inflation rose very sharply, and at around the same time output contracted. While there are many in the room that don’t need reminding, I thought I would just give the younger members of the audience a reminder of just how desperate those times were (Chart 1). In 1975, RPI inflation peaked just shy of a staggering 27% while at the same time output fell. It was this era that entrenched the term “stagflation” in the minds of the public. Inflation fell back sharply over the subsequent year or so, only to rear its head again in 1979-80 – this time peaking at around 22%. Once again output contracted and unemployment rose sharply (Chart 2). A third and final bout of rising inflation and falling output occurred in the early 1990s, with the unemployment rate once again rising above 10%. On average, inflation in the 1970s was around 13% and 7.5% in the 1980s. The UK macroeconomic framework Why was it that output and inflation were so volatile then and why has economic performance improved so much in the past 10 years? These questions are vital as we face more uncertain times ahead and to ensure that we avoid repeating the mistakes of the past. I would point to three main factors. There have been changes to the structure of the UK economy that have made it more flexible and adaptable.
Crucially we now have a credible framework for setting monetary policy to meet the inflation target in the medium term. Monetary policy cannot prevent the short-run ups and downs of economic cycles. In the current climate, the Committee believes that, if Bank Rate were set to bring inflation back to target too quickly, the result would be unnecessary volatility in output and employment. Instead we are focused on returning CPI inflation to the 2% target in around two years, when the present sharp rises in energy and food prices will have dropped out of the CPI inflation rate. We judge that in order for inflation to return to target it will be necessary for economic growth to slow this year, reducing the pressure on supply capacity of the economy and dampening increases in prices and wages. But the risks to both the upside and downside remain large and the MPC will continue to make its judgement about the appropriate level of Bank Rate month by month. The next year is not going to be comfortable for anyone and we already hear calls to change the system, the target, and our focus on inflation. But the new framework and the independence of the Bank was designed for difficult times as well as for plain sailing. I hope we can look to you and other businesses for support in doing what is needed to bring inflation back to target. BIS Review 80/2008  5  6  BIS Review 80/2008  BIS Review 80/2008  7