the wider economy – as slack in the labour market will tend to limit wage growth and thus the cost pressures faced by companies. but many companies face other cost pressures that are not related to their own capacity constraints or the ease with which they can hire staff. these “ other ” costs are the second factor. some of these costs relate to inputs that are imported, such as energy and other commodities, and so depend on movements in world prices and in the sterling exchange rate. others stem from domestic factors, including – importantly in the current context – changes in indirect taxes. the third factor emphasised by this type of pricing model is the mark - up over costs included in the final selling price which governs the return firms make on capital. as i will discuss later, there is some evidence to suggest that movements in this mark - up have been different in this recession than in previous ones. the final set of factors determining pricing decisions are expectations of future costs and prices. most companies change prices infrequently and as such their pricing decisions today are based on expectations about how their costs and their competitors ’ prices are likely to vary in the future. similarly, pay awards are likely to be affected by firms ’ and employees ’ expectations of future inflation. i will use this broad framework to consider why inflation has been above the 2 % target for much of the past four years and why inflation was higher than expected for much of this period. price level shocks it is not difficult to find factors that have pushed up inflation over the past few years. the economy has been hit by a series of large price level shocks – to oil and other commodity prices, to vat and to the sterling exchange rate – which have raised companies ’ costs and the key intuition of this model is based on work such as that by marshall ( 1920 ), chamberlin ( 1933 ), spence ( 1976 ) and salop ( 1979 ), among many others who contributed to this now well established literature. put upward pressure on prices. together these factors can more than account for the strength of inflation. the impact of the rise in oil prices and the changes to vat have been discussed quite extensively elsewhere and so i will not expand on them further this evening. 2 however, it is perhaps worth spending a few minutes considering the effects that the substantial depreciation of sterling has had on companies ’ costs and prices. sterling has depreciated by close to 25 % since mid - 2007. to get a sense of the potential impact

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. but what is different is that the current risks to inflation are unusually large. my central view is that these risks should gradually lessen as the temporary effects pushing up on inflation wane and the economic recovery continues. but it is possible that some of the risks will crystallise and policy will need to react. it is quite likely that in hindsight, once we see how the economy evolved and which risks materialised, that the current stance of policy will be criticised for having been too tight or too loose. but we cannot set policy with hindsight. all we can do is set policy in such a way that balances the opposing risks to inflation and be ready to change policy decisively in either direction as this balance of risks alters. i do not know when policy will next change or in what direction. but i can assure you that when making this decision, the objectives of policy will be clear and unchanging : inflation, inflation, inflation. references benito, a, neiss, k, price, s and rachel, ł ( 2010 ), “ the impact of the financial crisis on supply ”, bank of england quarterly bulletin, vol. 50, no. 2, pages 104 – 114. bils, m ( 1989 ), “ pricing in a customer market ”, the quarterly journal of economics, vol. 104 ( 4 ), pages 699 – 718. campa, j and goldberg, l ( 2006 ), “ distribution margins, imported inputs, and the sensitivity of the cpi to exchange rates ”, nber working paper no. 12121. chamberlin, e ( 1933 ), “ the theory of monopolistic competition ”, cambridge, mass. harvard university press. fisher, p ( 2010 ), “ why is cpi inflation so high? ”, remarks based on a talk given to merseyside young professionals, available at : http : / / www. bankofengland. co. uk / publications / speeches / 2010 / speech438. pdf haskel, j, martin, c and small, i ( 1995 ), “ price, marginal cost and the business cycle ”, oxford bulletin of economics and statistics, vol. 57, pages 25 – 41. ihrig, j, marazzi