8  See the box on page 5 of the July 2010 Agents’ summary of business conditions, available at: http://www.bankofengland.co.uk/publications/agentssummary/agsum10jul.pdf  BIS Review 122/2010  5  But it may also reflect the nature of this recession. Speak to almost any businessperson and they will tell you the same story: to be successful, businesses need healthy cash flow. Cash is king. That has always been the case. But one consequence of the financial crisis – as the availability of bank financed tightened and trade credit dried up – is that the importance placed on maintaining cash flows increased. Companies were less able to trade-off lower selling prices today for future gains in market share. 9 Inflation expectations The final factor emphasised by the pricing model is inflation expectations. The importance of inflation expectations is well understood. If wage and price setters expect the MPC to keep inflation close to target for much of the time, this will be reflected in their behaviour which, in turn, will help keep inflation close to target. Successful policy and anchored inflation expectations are self-reinforcing. A significant risk associated with the recent period of above-target inflation is that it causes inflation expectations to become less well anchored. The dangerous talk may start to be believed. If so, temporary deviations in inflation would tend to be given greater weight in wage and price setting and so become more persistent. And the task of monetary policy would become substantially harder.
It is difficult to know exactly how much spare capacity there is in the economy and what its precise impact is on inflation. But that there remains some slack in the economy and this is likely to be pushing down on costs and prices seems clear. That impact should become more apparent as the temporary effects associated with the shocks to input prices and VAT wane. It is perhaps noteworthy that in the US and euro area, which have not experienced falls in their exchange rates or large movements in indirect taxes, core inflation has weakened substantially. The downside risks to the growth outlook, stemming in particular from the substantial fiscal consolidation now in train and the continuing constraints on the supply of bank lending, add materially to the downside risks to inflation. And even if the economic recovery does continue, it is possible that some of the factors that may have contributed to the surprising strength in inflation in the past may start to fade. As demand increases, companies may begin to bring mothballed capacity back on stream. And as firms build up their cash balances and credit becomes more available, margins may start to fall as companies seek to enter new markets and gain new customers. The risks to the inflation target are real and substantial. The job of monetary policy is to try to balance these upside and downside risks to inflation. In essence this is no different to normal, monetary policy is always faced with a balancing act.