How do we know, in an uncertain and everchanging world, what precise path of interest rates is necessary to stabilise inflation in the medium term? That raises questions about both what we do and what we say. (a)  What we do: The role of money and the nominal anchor  Let me start with what we do and how we provide an anchor to the price level in the long run. With a paper currency, expectations that the future price level will remain stable are an article of faith. Such expectations are the basis of the trust without which people will not willingly use paper money. They reflect beliefs about how the central bank will react to events. Given our current arrangements, the anchor for expectations of the future price level is the judgement and character of the men and women who currently, and will in the future, serve on the Monetary Policy Committee. That is a crucial difference between money as a standard of value, where its value is determined by the judgement of a group of experts, and the standards of weights and measures, such as the metre, kilo or second, which are based on objective scientific measurement. I hope that one day the Governor of the Bank of England will be regarded as occupying a position similar to that of the Chief Executive of the National Weights and Measures Laboratory.13 For the time being the value of money will depend upon the discretionary judgements of the MPC.
Structural improvements in the labour market are, however, unlikely to explain the full improvement in the stability of inflation and output. They cannot explain the low and stable level of inflation expectations. Changes in the yields on government bonds indicate that investors’ expectations of inflation over the medium-term – and the premium they require to compensate them for the risk of future inflation – have also fallen significantly. Chart 5 shows the sharp fall in expected inflation that resulted from the actual announcement of independence for the Bank of England in 1997. It seems to me likely that the new framework for monetary policy has been a key, though not the only, driver in moving the frontier inwards. By eliminating uncertainty about the inflation target and ensuring that the objective of low and stable inflation is well understood and credible, the change in the framework in 1997 helped to anchor expectations of inflation in the medium term. By doing so, it has made it possible for the MPC to keep inflation closer to target with smaller changes in monetary policy, and hence fluctuations in output, than would otherwise have been the case. The anchoring of inflation expectations has changed the way businesses respond to unexpected shocks. Faced with changes in their costs stemming from, for example, changes in import or energy prices, businesses can respond in two ways, each consistent with the necessary change in employees’ real take-home pay. They can pass those cost changes forwards to prices or backwards to money wages.