capacity of the economy to meet that demand. we came to recognise that direct controls merely addressed the symptoms of instability rather than its causes. we realised increasingly that fiscal policy was not well suited to the task of short - term demand management, and needed to be constrained within prudent limits if debt levels were to be sustainable in the medium - and longer - term. and this left a more distinctive and clearly defined role for monetary policy as the primary instrument for maintaining broad balance consistently over time between aggregate demand and underlying supply. all this has become the accepted wisdom just about everywhere. since 1992 in this country the explicit objective of monetary policy has been to achieve stability defined in terms of a target for retail price inflation. and since 1997 the bank of england - through the monetary policy committee - has been delegated responsibility for setting short - term interest rates with the consistent aim of hitting the government's symmetrical 2½ % inflation target ( on a precisely defined measure of retail price inflation - rpix ). now the reason we've been set that task is not - as some people imagine - because either we or the government think that consistently low inflation is the be all and end all of economic life. it is because we learned from our earlier experience that consistently low inflation is a necessary ( though not in itself a sufficient ) condition for the sustained growth of output of the economy as a whole, for high levels of employment, and for rising living standards, which are more fundamentally the things that we are all seeking to achieve. " stability is a necessary condition for sustainable growth " has become the universal central - banking credo. so our objective - and the reasons for it - could not be clearer. but meeting that objective is not as straightforward as it may sound. the reason, of course, is that there is no simple, direct, link between our essential instrument - the short - term interest rate - and our objective, the rate of inflation. interest rates essentially affect the demand side of the economy. they do not directly influence the supply side, which depends upon a whole host of structural characteristics of the economy which are largely beyond the direct reach of monetary policy. what we have to do in managing short - term interest rates is to keep overall demand growing broadly in line with the underlying - sustainable supply - side capacity of the economy as a whole to meet that demand. in other words we are trying to maintain overall, macro - economic, stability in a much broader sense, in the medium - and longer

time to have their full effect, so our decisions have to be forward looking. we start from a position in which inflation is in fact running - and has been running for some months slightly below the government ’ s 2½ % target. the november figure was 2. 2 % and within this goods price inflation was running at around only ½ %, while retail services price inflation was running at nearly 4 %. on europe ’ s hicp measure, inflation in november was running at 1. 3 %. in part this out - turn reflects the abnormal international developments i have already discussed. the slowdown in the world economy reduced external demand in the uk. weak world demand was accompanied initially, too, by falling commodity and manufacturing input prices. and sterling ’ s strong exchange rate had a direct, dampening, impact on our domestic price level. it is clear that world demand has now started to strengthen and commodity prices generally have stopped falling. and the oil price has already recovered strongly - which may benefit the scottish economy but puts upward pressure on inflation. but sterling ’ s exchange rate remains uncomfortably strong. looking ahead, there are a number of unusual factors that might help to hold the rate of inflation down, at least in the short term. some of these are one - off administrative measures rather than broader economic influences : they include the unusually large price reductions imposed by utilities regulators to come into effect in the spring as well as the chancellor ’ s decision to end automatic over - indexation of excise duties on fuel and tobacco. but there is also evidence, which is harder to evaluate, of more intensive retail price competition, squeezing retail margins, and that could hold down prices at least for a time. and this last effect could intensify and extend further into the future as a result of the spread of e - commerce. meanwhile we are faced with familiar uncertainties about the prospective strength of domestic demand and about overall demand pressure. final domestic demand growth, including the growth of consumer spending, did apparently moderate in the middle of last year - as it needed and still needs to do. but there is plenty of evidence to suggest that consumption growth will in fact remain quite buoyant : the strength of the equity market ; rising house prices - certainly led by london and the south - east but followed, not all that far behind, by edinburgh, and spreading out across the uk ; strong borrowing, including mortgage equity withdrawal, by the household sector ; and rising incomes from employment. meanwhile, on the supply side