quite persistent as it takes time for prices to adjust. that is not surprising, as companies know that foreign exchange markets are volatile and so the initial response of prices to an exchange rate change is likely to be relatively small. but the longer it persists, the more likely it is that sterling prices will adjust to euro prices, creating the potential for quite long term impacts on uk inflation relative to the euro area. that is what we appear to be seeing at the moment, with the historic relationship shown in chart 6 suggesting that uk inflation could run 1 to 2 percentage points above euro area inflation for a considerable while unless there is some noticeable appreciation in the value of the pound. the counterargument to this view is that the recent substantial depreciation of the pound against the euro and other currencies is needed to support a rebalancing of the uk economy and sustain the growth of uk manufacturing and other internationally competitive sectors of the economy. but the extent of the depreciation of sterling since 2007 has been much greater than we have seen in previous rebalancing episodes, such as the mid - 1990s – which raises the question whether sterling has fallen much further than needed. 5 and it is not clear see sentance ( 2011 ) for a comparison of the recent fall in sterling with previous episodes. bis central bankers ’ speeches that the export - based manufacturing activities which could benefit from a large depreciation have the capability to respond quickly by scaling up output – particularly when their demand is already being boosted by a recovery in global demand. chart 7 manufacturing output in uk, euro - area and sweden rebased to 100 in 2007 uk euro - area sweden source : eurostat and thompson datastream chart 8 goods exports from uk, euro - area and sweden rebased to 100 in 2007 uk euro - area sweden source : eurostat and thompson datastream bis central bankers ’ speeches the performance of uk manufacturing output and exports relative to other regions and countries which have maintained stronger currencies – such as the euro area and sweden – supports this view. chart 7 shows that there is very little difference in the current level of output relative to its pre - recession level in the uk, sweden and the euro area – though the depreciation in the pound may have helped shield manufacturers from a bigger decline in output during the recession. chart 8 shows broadly the same picture for the exports of goods, which are dominated by trade in manufactured products. this picture is perhaps not that surprising when we think

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 euro - sterling exchange rate sterling eer * average eer *, 97 - 07 * : 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 uk has an independent monetary policy, it is a member of the single european market which covers all european union economies. the benchmark prices of traded goods in the european market will be set in terms of euros, reflecting the fact that this is the currency in which most european producers will have their costs and revenues denominated. so when the pound falls against the euro, producers will tend to raise their prices in sterling terms to maintain euro revenues, creating a positive uk - euro area inflation differential, as we have seen recently. by the same token, the weakness of the euro against the pound in the first half of the last decade created a negative uk - euro area differential with uk inflation running below continental european countries. chart 6 euro - area / uk inflation differential and exchange rate euro / sterling % 0. 3 2. 0 1. 5 0. 2 1. 0 0. 1 0. 5 0. 0 - 0. 5 - 0. 1 - 0. 2 - 1. 0 euro - area / uk cpi differential ( rhs ) * - 1. 5 euro - sterling exchange rate ( lhs ) * * - 2. 0 - 0. 3 - 2. 5 - 0. 4 - 3. 0 1997 1998 1999 2000 2001 2002 2004 2005 2006 2007 2008 2009 2011 * : euro - area cpi minus uk cpi. a negative differential implies higher uk inflation. * * : expressed as the deviation from its average over the same period. source : thompson datastream chart 6 suggests that this inflation differential can be