Events are still moving quickly, so I hope you will understand why I am not going to attempt a live commentary on events. I hope that the massive and far-reaching measures the US Government has now announced will restore greater calm and confidence in their banking system. Stabilisation of US markets and banks should have a beneficial knock-on effect on wider international markets too. But we will continue to monitor the situation closely, in consultation with our counterparts in the US and elsewhere, in order to judge whether any further measures are needed. Inflation outlook This morning I want to take a wider perspective and discuss how the credit crunch is affecting the wider UK economy and draw some medium-term lessons for economic policy. BIS Review 114/2008  1  And the first point to make is that the turmoil in financial markets has not been the only shock to our economy in the last 12 months. In any other week more attention would have been given to the fact that for the second successive quarter the Governor had to write an open letter to the Chancellor on behalf of the Monetary Policy Committee to explain why inflation was more than a percentage point away from the target of 2%. In fact inflation has risen from 2.1% in December to 4.7% in August and it seems set to peak above 5% soon. The immediate driver of that increase has been the international commodity cycle (Chart 1).
But the same arithmetic applies: such price level shocks need have no long-term impact on the inflation rate. In the medium term the real upside risks to inflation lie at home – in whether we see “second round” rises in wages and prices in the domestic economy. It is to counter those pressures that the MPC have judged it necessary over the last year for growth to slow and create a margin of spare capacity in our economy. That makes it more difficult for companies to raise prices and puts more pressure on them to restrain their costs. It also re-emphasises our determination to get inflation back to the 2% target and thus influences the expectations of financial markets, price setters, wage negotiators and households generally. And expectations themselves have an important impact on inflation. Broadly, the higher households’ expect inflation to be, the less they are likely to save today. Inflation expectations also shape workers’ wage demands as they try to protect their standard of living. And companies’ expectations will shape the prices they set as well as their willingness to concede cost increases. We know from the inflations of the 70s, 80s, and early 90s that raising interest rates will in time bring inflation down, even when expectations of future inflation are high. But we also know how painful that process is. It works through the increased threat of bankruptcy and unemployment. That forces a change in peoples’ behaviour and their hearts and minds and expectations follow.