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GDP falls by half a per cent: King speech; - Third, the combined effect of the recent changes to the standard rate of VAT, including the rise to 20% this month, is likely to push up the level of prices by around 1½%. Taken together, those three factors by themselves would account for a remarkable 12% addition to the price level over four years, or an average increase in the inflation rate of 3 percentage points a year. Since the consumer price index as a whole rose by not much more, the contribution of domestically generated inflation over that period was close to zero, and obviously well below the target. It has always been understood that supply shocks – shocks such as these that move output and inflation in opposite directions – pose a dilemma for monetary policy. Should inflation be brought back to target quickly, reducing the risk of a rise in inflation expectations, or more slowly, reducing the impact of the shock on output? Let me quote what I said in 1997 about how the MPC would resolve that dilemma: "Many supply shocks are price level effects. For example, changes in indirect taxes or commodity prices often affect the domestic price level but do not in themselves change the underlying rate of inflation. An appropriate monetary response is to accommodate the first round price level effects, while ensuring that changes in the published twelve-month inflation rate do not alter inflation expectations and lead to second round inflationary changes in wages and prices. Since shocks may take several months to have their full effect, a horizon of about two years is a reasonable one over which to try to bring inflation back to its target. But if shocks are sufficiently large – in either direction – then it may be sensible to extend the horizon over which inflation returns to its target level." The numbers I have given you make clear that, on this occasion, the MPC has not accommodated any second round effects. In fact, after the event, it is clear th...