If the private sector continues to grow – in line with the latest business survey evidence – and headline inflation remains high, it is hard to see why private sector pay settlements should not return to their pre-recession average of around 3.5% and possibly move higher.9 Issue 4: Inflation expectations and credibility That brings me to my final key issue – the role of expectations and credibility in the framework for monetary policy. Chart 12 shows a diagram which I have used in a number of speeches now and which I believe sums up well the challenge that the MPC faces in trying to stabilise UK inflation in a potentially volatile global economy. The global economy affects inflation in the UK through the cost of imports, the impact of world demand on the UK economy and through the way in which international businesses perceive the pricing climate changing on global markets – which will have an impact on their pricing strategies here in the UK. All these factors can affect UK inflation – but monetary policy has three powerful counter-influences: the influence of monetary conditions on the exchange rate and the level of domestic demand, and the ability of the monetary authorities to anchor price expectations through their commitment to the inflation target or some other monetary anchor.
That, in turn, would have provided some offset to the global inflationary pressures we have been experiencing over the past year. Instead, as Chart 5 shows, sterling has remained relatively weak, both against the full trade-weighted basket of the currencies of our trading partners, and particularly against the euro – which is the most important currency for UK trade, with the euro area accounting for around half of our total exports and close to half of total UK imports. Chart 5 Sterling depreciation since 2007 Rebased to 100 in January 2005 110 105 100 95 90 Euro-Sterling exchange rate  85  Sterling EER *  80  Average EER *, 97-07  75 70  2005  2006  2007  2008  2009  2010  2011  *: Effective exchange rate Source: Thompson Datastream and Bank for International Settlements  This weakness of sterling is one of the key reasons why UK inflation has been much higher than our peer group of European economies. As Chart 6 shows, the differential between inflation in the euro area and the UK is closely associated with the relative strength and weakness of the sterling/euro exchange rate. And there are good reasons for this. While the  BIS central bankers’ speeches  7  UK has an independent monetary policy, it is a member of the Single European Market which covers all European Union economies.