Speaking in 2003, Mervin King, the Governor of the Bank of England described the previous ten years as the ‘nice’ or Non Inflationary Consistently Expansionary decade. His view that the next period would present greater challenges has been borne out by events.

Bank officials, including the Governor, however, were at pains to point out that although the change in the conduct of monetary policy contributed significantly to the ‘nice’ environment, it had not been the sole cause.

The fact that other countries have also enjoyed a degree of low and stable inflation and stable growth, suggests that other forces have been at work.

For the UK there have been two in particular, a sharp jump in globalisation being the first and a boost to the UK labour supply as a result of both external and internal factors, being the other.

UK monetary policy changed significantly in 1992 with its move to an inflation target (see Macroeconomic Policy 4.2 Monetary Policy - Indirect controls - policy strategy).

Since inflation is known to lag excess economic activity, the change has meant that monetary tightening or loosening has become much more proactive, much less reactive.

Rather than respond to changes in inflation as they arise, policy decisions are now taken on the basis of what inflation is expected to be in 18 months to two years given current economic conditions.

The initial target was to bring underlying inflation, as measured by RPIX (the Retail Prices Index excluding mortgage interest payments) to the bottom half of a 1 – 4% range.

The Labour Government further refined the inflation target policy when it came to office in 1997 by introducing a two-tailed target where undershooting the 2.5% target was as serious a policy error as overshooting it.

Mr Brown’s other important innovation was to hand over the responsibility for setting interest rates to the Bank of England.

More recently the RPIX target has been swapped for a Consumer Prices Index target of 2% but with the trigger points of plus and minus one percentage point remaining in place.

Following the changes to monetary policy, the most important influence on the UK economy has been the increasing role played in the global economy by China, India and the countries making up Eastern Europe.

The emergence of these areas with an abundance of cheap labour has led to structural changes in many advanced economies, not least the UK, with low value added, labour intensive manufacturing and tradable services being the main casualties.

The output from these industries has been vulnerable to replacement by cheaper imports or the production process itself has been shifted overseas.

For the Monetary Policy Committee, globalisation meant a number of changes to the economic environment in which the Committee operated.

• First, it increased the UK’s terms of trade, i.e. raised the price of the UK’s exports relative to its imports, thereby also increasing the real purchasing power of the UK’s economic agents and allowing faster economic growth for a given inflation rate or lower inflation for a given growth rate.
• Second, globalisation, by increasing import shares ensured that when domestic demand was stimulated, more of that increase would leak abroad. It also, because of competitive pressures, probably made home producers less likely to raise prices in response to a pick up in domestic demand. The result, again, was to flatten the short term trade off between inflation and economic activity.
• Finally the build up in savings in these countries and its reallocation around the world put downward pressure on real longer term interest rates which in turn supported global demand.

The UK economy also benefited from an expansion of the UK labour supply as a result of both domestic and external factors.

Domestically there has been a fall in the natural rate of unemployment and an increase in the participation rate, and externally there has been an increase in net inward migration into the UK largely from those Eastern Europe countries which have become part of the EU.

On balance it is likely that this supply shock has tended to reduce inflationary pressures. For once, the UK economy did not falter as a result of the old ‘wage-price spiral’ as it had so often in the past. The availability of additional sources of labour helped to prevent a surge in earnings growth.

The outcome of first the change to inflation targeting and then its refinement plus the boosts from globalisation and an expanded labour supply was a decade and a half of consistent but sustainable growth, low and stable inflation and low and stable interest rates.

The following chart shows how benign the period from 1993 to 2007 was when compared with the previous two decades.

• The blue boxes represent the range of inflation rates in each five-year period with the middle line representing the average rate.
• Similarly the red boxes represent the range of GDP growth rates.

It is noticeable that the 1990s saw a return to low and stable inflation and consistent and sustainable growth following the volatility of the 1970s and 1980s.

Between 1992 and 2007, GDP grew by over 50%, equivalent to an annual average growth rate of nearly 3%.

But, as important, is the fact that the annual rate of growth did not fall below 1.9% nor did it rise above 3.8%, apart from one year, 1994, when the economy grew by 4.3% taking up some of the huge amount of slack in the economy which had built up during the earlier recession.

The stop-go cycles of the past were avoided in this period, providing an economic climate in which companies could better plan and invest.

The heady 5% or higher growth rates which were achieved during the 70s and 80s might have been absent, but so too were the recessions which naturally followed those booms as the authorities dealt with the consequent increase in inflation.

The chart below illustrates how a proactive policy combined with increased credibility and transparency has ensured that interest rates need not be raised as high.

Since 1992, base rates have averaged under 6%, and have shown minimal volatility. Indeed the peak of 6% in the last cycle was the lowest since 1961.

In contrast, the average for base rates in the previous fifteen years was just under 12%, with a low of 7.5% and a high of 15%.

An apt analogy is with driving. Waiting until inflation is rising before policy is enacted is like tailgating. The probability is heightened that at some stage there will be a need to stamp hard on the brakes to avoid a crash.

In contrast, maintaining a safe distance from the vehicle in front by careful use of the brake and accelerator means that when danger arises, a much gentler response is sufficient to slow the vehicle and avoid a collision.

But proactive policy and low inflation not only resulted in lower and less volatile interest rates.

The belief that inflation will remain low for the foreseeable future meant that longer term interest rates were much closer to short term rates than hitherto.

This opened up the market for cheaper longer term borrowing for individuals, companies and the public sector (see Macroeconomic Policy 4.2 Monetary Policy - Interest rates and yield curves).

The long period of unbroken growth came to a juddering halt in 2008 and the UK economy once again slid into recession.

The borrowing that the low interest rates and liberal lending policies of the banks encouraged was pushed to the limit. At the end of 2008, consumer debt totalled £1.5 trillion, equivalent to 160% of earnings. Clearly households had taken full advantage of the new financial environment and took it to the extreme.

It has been a very steep learning curve for both lenders and borrowers and both groups will have learned hard lessons as a result of being the first participants in the era of cheaper money.

The latest episode will also have proved a salutary lesson for the authorities who will have realised the hard way about the limitations of inflation targeting and of a one tool (i.e. interest rate) monetary policy.

Especially important will be how the authorities learn to deal with asset price bubbles, such as soaring house prices, when the target covers just retail price inflation and also how to react in situations when Bank Rate loses its efficacy as it approaches zero.