As a result, many countries have been able to bring down inflation at virtually no cost. In this respect, we can probably talk about some degree of endogeneity in inflation. However, it is still the non-trivial task of monetary policy to ensure that inflation remains low and stable on a more permanent basis. In a country with its own national currency, inflation is not something that just drifts in with the wind from abroad. It is the monetary policy choices we make that determine price developments over time. As Ken Rogoff, professor of economics at Harvard University, has so aptly phrased it: “…any central bank, no matter how small or open its economy, can always stabilise domestic prices at medium- to long-term horizons, should it choose to do so…Globalisation may affect the parameters of central bank models, but independent central banks still control their own inflation destinies…”. 8 For some years now, the short-run trade-off between inflation and economic growth has been extraordinarily favourable. Inflation has been low and economic growth high. We have been hit by massive and long-lasting positive supply shocks thanks to the globalisation process. To accommodate a higher growth potential and to maintain the nominal anchor, central banks worldwide for a long period held short-term interest rates well below what can be regarded as a normal level. Furthermore, long-term real interest rates have declined markedly since the 1980s and the beginning of the 1990s and have been especially low in recent years.
The UK Government has already introduced a range of measures to underpin the banking system, including requiring the injection of additional capital, guaranteeing bank debt and providing insurance against losses on some of the risky assets on banks’ balance sheets. That has served to stabilise the banking system. But we are still some way from having banks that feel sufficiently secure that they can lend normally, and investors that have enough confidence in the banks to provide them with sufficient funds. The Bank will continue to work alongside the Government and the FSA in trying to ensure an adequate flow of funds to business. Unfortunately, past experience in other countries suggests that it often takes time for the banking system to mend after a crisis, and it is possible that the supply of credit will remain impaired for some while. There are two reasons for optimism about the strength of the recovery. First, we have the advantage of a substantial depreciation in sterling, whose trade-weighted value is about a quarter down on its value before the crisis broke. That should encourage buyers to switch to goods and services made in this country and make it more profitable to produce them. As a result, it should facilitate the necessary re-balancing of the economy. Second, an unprecedented policy stimulus is working its way through. In particular, the Monetary Policy Committee has lowered Bank Rate to 0.5%, a level unmatched in the Bank's 315-year history and only marginally above its floor of zero.