not the same as general deflation. in fact price stability, in the sense of an inflation rate overall of around 2½ % a year, is likely to mean that the prices of manufactured goods will, on average, not rise at all. faster productivity growth in manufacturing than in services, averaging around 2 % over the last twenty years, means that the prices of services will rise faster than those of manufactured goods. and the rise in sterling over the past five years increased the difference between inflation rates in the two sectors. table 5 shows the inflation rates for goods and services in the major economies. positive rates of inflation for services, which account for around half of consumer spending, show deflation in most of the world economy is still some way off. in all countries over the past decade the gap between goods and services price inflation reflects productivity differences. that gap has widened somewhat in recent years as increasing competition from new producers has driven down prices of tradable goods. but the striking feature of the table is the extent to which the difference has increased to no less than 5. 7 percentage points in the uk, much more than in the us where in turn the gap is larger than elsewhere. exchange rate movements are largely responsible for these differences. the extent to which services inflation has risen relative to goods inflation is another manifestation of the imbalance within the uk economy. table 5 total, goods and services inflation uk us euro area japan cpi inflation ( year to aug 2002 ) 1. 9 1. 7 2. 2 – 0. 9 cpi goods – 1. 1 – 0. 1 1. 4 – 1. 6 cpi services 4. 6 3. 1 3. 3 0. 0 services - goods infl. 5. 7 3. 2 1. 9 1. 6 services - goods infl. ( 1990 - 97 ) 1. 6 1. 6 1. 6 1. 3 services - goods infl. ( 1990 - 2002 ) 2. 3 1. 8 1. 3 1. 3 note : inflation rates are calculated as the total increase in the price index over the indicated period, based on monthly data, expressed as a 12 - month growth rate. source : ons ( for uk data ) and thomson financial datastream ( for data on the euro area, us and japan ). deflation - in the sense of a sustained fall in the aggregate price level - can be found among the g7 economies only in japan, where the consumer price level has been falling almost continuously for

) over the period indicated. data up to 2002 q2. source : bank of england calculations based on ons data. it is, of course, difficult to identify the effect of changes in the monetary policy regime on the path of total output. one approach is to consider long runs of data which make it easier to identify structural breaks in the behaviour of output. luca benati of the bank of england has been investigating the statistical properties of inflation over long periods for a number of countries. he finds that changes in the behaviour of inflation appear broadly to coincide with changes in the monetary policy regime. some tentative evidence that this general conclusion applies to the uk can be found in the behaviour of ten - year forward interest rates on uk government bonds. at this horizon, high and variable interest rates are signs of high expected inflation and a large inflation risk premium. as shown in chart 3, the ten - year forward interest rate has fallen significantly in recent years, and has been less variable since inflation targeting, and especially the mpc, were introduced. what is the mechanism by which monetary policy contributes to a more stable economy? i would argue that monetary policy is now more systematic and predictable than before. inflation expectations are anchored to the 2. 5 % target. businesses and families expect that monetary policy will react to offset shocks that are likely to drive inflation away from target. in the jargon of economists, the “ policy reaction function ” of the bank of england is more stable and predictable than was the case before inflation targeting, and easier to understand. more simply, monetary policy is not adding to the volatility of the economy in a way that it did in earlier decades. the behaviour of monetary policy in the united kingdom after 1992 more closely resembles a “ taylor rule ” that has been shown to fit data in the united states than was the case before 1992. see the work of ed nelson of the bank of england ( nelson 2000 ). chart 3 ten year forward rates in the uk 1970 - 2002 note : implied forward nominal rates on conventional gilts ten years hence, calculated on the last business day of the month. source : bank of england. 3. the case for price stability : what have we learnt over the past 10 years? the costs of departing from price stability - either inflation or deflation - depend upon whether it is expected or comes as a surprise. in his 1992 lecture, lord kingsdown distinguished three costs of unanticipated inflation and four of anticipated inflation. i shall focus