The rapid expansion in activity in these economies has inevitably put pressure on the global price of energy and other raw materials, whose supply is relatively fixed at least in the short run. That is showing up in rising inflation world wide (Chart 5). So is it right to conclude, as some have, that the path of inflation is determined abroad? Certainly commodity prices have an effect in the short run. But it is domestic monetary policy – the decisions that the Monetary Policy Committee take each month, together with the overarching framework that defines our target – that determines the path UK inflation in the medium-run. The MPC will continue to assess the balance between the risks of higher inflation from the commodity cost shock and the downside risks to output (and to inflation in the medium term) from the credit crunch. But I can assure you that we will do whatever it takes to bring inflation back to target in the medium term.
That transfer is bound to hit real wages one way or another but the more that is resisted and nominal wages are pushed up, the greater the cost is likely to be in unemployment and slower growth. We have no direct lever on public expectations. We need not just to assert our determination to bring inflation back to target but ensure that our words are credible. So, in setting interest rates we need not just to assess the balance between supply and demand pressures in the economy which will set the context for price and wage decisions in the medium term, but also ensure that our decisions are understood and seen to respond to the economic developments in inflation and output that people are experiencing. 4  BIS Review 94/2008  It is clear that with inflation rising well above target we need a period of slower growth to create a margin of spare capacity. The questions we discuss and reconsider each month are how big a margin is necessary and what level of interest rates is needed to bring it about. The Credit Crunch On the scale of the necessary output gap, for example, we need to take account of the supply effects of the doubling of oil prices and the impact of migration. On the other side we need to judge how sharp a slowdown is already in train. In deciding the necessary level of interest rates we need not just to focus on the level of Bank Rate.