own assessment of near - term inflation, but the rise in longer - term measures has been considerably more muted. and measures derived from inflation swaps suggest that the expectations of financial market participants five years ahead have remained stable. but given the unexpected strength of inflation in recent months, this risk has probably increased of late. so we shall be watching these indicators, and their impact on wages and prices, like proverbial hawks. what are the implications of all this for monetary policy? the recovery has so far turned out to be broadly in line with that expected a year ago, but the outlook for growth remains highly uncertain. though inflation has been running well above target and is likely to continue to do so for a while yet, beyond the end of next year it should fall back to near the committee ’ s 2 % target. in the light of that outlook, i believe we have made appropriate use of the “ constrained discretion ” granted to us in the chancellor ’ s remit, looking through the temporarily elevated inflation to the medium term in order to avoid unnecessary volatility in output. tightening policy sharply in order to deal with the currently elevated level of inflation would simply have put a brake on the recovery unnecessarily and would have made inflation more likely than not to fall below the target in the medium term. if all goes to plan, however, and private final demand continues to pick up the baton as the fiscal consolidation proceeds, then the margin of spare capacity will shrink and it will at some juncture become appropriate to begin withdrawing the current extraordinary degree of monetary stimulus. and, when that point comes, the mpc will aim to do so in a timely, but measured, fashion. as 2010 draws to a close, the good news, then, is that the recovery, here and more widely, has remained on track, following the sharpest downturn in activity since the great depression. such an outcome was by no means guaranteed twelve months ago ; for that we must be grateful. but there remain significant challenges for the year ahead. in many developed countries, the after - effects of the financial crisis still linger, in the form of banks that are still overly reliant on official support, fragile household and business confidence, and bloated public sector deficits and debt. moreover, the rapid recovery in emerging markets has reawakened global inflationary pressures. and here in the united kingdom, inflation has been running above the mpc ’ s 2 % target for an uncomfortably

the aftermath of the collapse of lehman brothers, this was arguably the most significant transmission channel to the real economy. an intensification of the sovereign debt problems in the euro area could therefore administer a blow to the recovery here. but given the very high degree of uncertainty, there is little that the mpc can do to deal with this risk ahead of crystallisation. while uk output growth has come in much in line with our expectations, the same cannot be said of our primary objective, inflation. back in august of last year, our central projection was for cpi inflation to be around 1. 5 % now. but inflation has been markedly stronger than that – 3. 2 % on the latest reading. why has inflation been so much higher, especially given that our expectations for growth have largely been fulfilled? there are three factors that account for this. 3 first, energy and non - oil commodity prices are substantially higher than in the summer of 2009. by convention, we base our forecasts for these variables on futures prices, which were relatively flat at that time. the buoyancy of commodity prices since then reflects the rebound in global activity, and especially the strength in the emerging economies. in addition, temporary supply factors have boosted the prices of some agricultural commodities. at present there appears to be a margin of spare capacity in the oil market, so that may permit global growth to remain strong without putting further upward pressure on energy prices immediately. but a low elasticity of supply of other commodities means that their prices, relative to those of finished goods and services, may continue to drift upwards. that would constitute an additional headwind for the united kingdom. a second factor behind the unexpectedly high inflation appears to have been greater than expected pass - through into final prices from the depreciation of sterling after august 2007. evidence from the united kingdom and other countries during the great moderation suggested that pass - through had fallen, perhaps because inflation expectations were better anchored. we expected something similar on this occasion too. in the event, the strength of uk goods inflation, relative to that in the other g7 economies, suggests that the passthrough of the depreciation was in fact rather greater, and similar to that before the great moderation. the third potential ingredient behind higher inflation is a more moderate drag from the margin of spare capacity in the economy. pay growth has been subdued during the recession, and that has helped to ensure that unemployment has risen far less than many commentators feared. rather the puzzle