Again simplifying, two features are added to the diagram to bridge from firms’ so-called ‘output’ – or wholesale – prices to the retail prices which the Bank targets. First, as well as being an input to producing firms, some imports are directly consumed by households. Second, distributors – including, most obviously, retailers – add another mark up, reflecting their own costs and desired profit margins. Changes in the economy affecting any of the links in this (stylised) chain will have a bearing on inflation dynamics. The challenge is to separate out cyclical, or temporary, factors from the more structural influences that over some periods alter firms’ costs and margins. That is important for policymakers, as to form a view on the medium-term outlook for inflation we need to distinguish between short-lived and persistent influences. Monetary regime change The monetary framework is one such structural influence. One of the most encouraging features of the post-1997 landscape has been that, as well as inflation tracking the target fairly well, expectations of inflation have been well anchored to the target (Chart 4). Uncertainty about future inflation has also fallen3 (Chart 5 ). It was different in the past. A characteristic shared by the various monetary regimes tried out by UK governments during the 1970s and 1980s was that no one could easily judge what rate of inflation the authorities were trying to achieve – or, therefore, have much idea about the outlook for inflation.
If so – if risk premia were systemically lowered – that would tend to reduce firms’ cost of capital and increase households’ financial wealth. Alternatively, the price of risk may just be temporarily low, possibly too low.8 The upshot is that we cannot yet be confident about the durability and macroeconomic implications of the changes seen in the financial environment. Mark ups It is a commonplace that competition has intensified. This is associated with ‘globalisation’. The facts are familiar. World trade has grown relative to world output (Chart 13). A wide range of emerging-market economies, notably in Asia, have become material participants in the world economy. Some UK businesses have relocated part of their production, or outsourced to firms operating in markets with cheaper labour costs. Partly reflecting these developments, although also increased specialisation, the share of imports in UK business investment and in consumption has steadily risen (Chart 14). 6  ‘The financing environment for smaller firms over the last decade’, in Finance for Small Firms – An Eleventh Report, Bank of England, 2004. 7  Hewitt, A. (2003), ‘Asset Finance’, Bank of England Quarterly Bulletin, Summer 2003. 8  See, for example, section 2 of ‘Financial Stability Conjuncture and Outlook’ Financial Stability Review, December 2004. 4  BIS Review 16/2005  These developments make markets more contestable. As does effective competition policy. An example in recent years was the car market, where prices converged with those prevailing on continental Europe.