Bank of England – Page 15 – Digital Finance Analytics (DFA) Blog

Macroprudential Policy: from Tiberius to Crockett and beyond

In a speech to TheCityUK Jon Cunliffe charts the development of macroprudential policy and the establishment of the macroprudential policy framework in the UK by the Bank of England’s Financial Policy Committee (FPC) since the Committee’s inception in 2011. He also looks ahead at some of the policy questions facing the FPC.

A key outcome of the financial crisis was the recognition that international standards were needed not just to ensure that individual banks were safe but also to ensure that the financial system as a whole was safe. The crisis showed that there are powerful dynamics in the financial system itself which drive booms in good times and busts in bad times. Seven years on from the crisis and four years from the establishment of the FPC, Jon says it is fair to ask how well regulators have done in putting in place the machinery to manage those risks and whether these have come at the expense of economic growth.

The contours of the new regulatory framework are clear and agreed and implementation is well underway, Jon notes, citing rules on bank capital and liquidity, resolution and work on addressing risks from outside the banking system, for instance from derivatives.

But he argues that this “standing framework” can only go so far in addressing risk. The role of macro-prudential authorities like the FPC is not just to ensure that regulations address the risk that financial firms and banks can pose to the financial system as a whole. It is also to monitor the build-up of risk and the development of new types of risk and to take action to address them.

In this area, macroprudential policy is at a much earlier stage of development, partly because the focus has so far been on creating the framework for policy, partly because there are still differing views internationally as to what time-varying, countercyclical macroprudential policy should and could do. Nonetheless, the FPC has taken some important steps here.

First, using macroprudential policy to address changing risks depends upon a clear assessment of risks and of the action necessary to address them. This is why the FPC has changed the structure and content of the Financial Stability Report. “The intention is that such a shorter, more focussed report will create a discipline for the FPC’s thinking, aid its communication and make it easier for others to hold us to account.”

Second, the Committee is developing the use of stress testing to assess macroprudential as well as microprudential risk. “At present we are using stress testing to help us judge how resilient the banking system is to different, severely adverse, but plausible, scenarios. A development of this approach would be to use stress testing more countercyclically. Rather than testing every year against a scenario of constant severity, the severity of
the test and the resilience banks need to pass it would be greater in boom times when credit and risk is building up in the financial system and it has further to fall, and then reduced in weaker periods when there is less risk in the system and the economy needs the banking system to maintain lending.”

Thirdly, the FPC has been looking at macroprudential risks beyond the banking system. Its recommendation on portfolio limits for high loan-to-income mortgages is an example of the committee taking a broad view of financial stability that goes wider than direct risks to the banking system.
On the question of whether financial regulation has gone too far, Jon says only now that reforms are being implemented is it possible for policymakers to see the whole picture of how they work together in practice and that some adjustments will be needed. “Given the depth and complexity of the financial crisis and the corresponding depth and complexity of the reforms, we should expect rather than be surprised that we will need to refine and adjust some of the regulatory reforms.”

However, while some adjustments may be necessary as we see how the reforms work in practice, Jon warns against seeking more generally to trade-off between financial stability and growth and notes that the post-crisis world requires a major adjustment in bank business models.
Jon also points out that in the long build-up of the credit cycle ahead of the crisis, while lending nearly doubled this did not lead to a very large increase in the financing of companies. Instead, lending was mainly directed to other financial institutions, mortgages and real estate.
“While we have relearned some familiar lessons in recent years, we have also learned some new ones. We have had to develop a new regulatory framework, macroprudential institutions like the FPC, and new policy approaches. Over the next few years we will certainly need to refine all of these. The implementation of the detailed reforms will inevitably throw up unforeseen effects in particular places, and where it is justified, we
will need to revisit issues. But we should be careful about talking about turning back the overall regulatory dial or trying to trade off the risk of financial instability for short-term growth.”

Financial Stability and Monetary Policy

Released by the Bank of England, “Don’t just do something, stand there”… (and think) was David Miles final speech as an external MPC member reflects on the past six years of low interest rates, the lessons we can take from the financial crisis and where monetary policy might go from here. In particular he discusses the value of using macro-prudential tools versus interest rates in tackling financial instability.

Speaking at the Resolution Foundation, David explains that when he joined the MPC in June 2009, interest rates had already been cut to the record low of 0.5% and the Bank bought £75 billion of government assets via its quantitative easing programme. At the time no one on the Committee would have predicted that more than six years later Bank Rate would still be 0.5%; that the Bank would have made a further £300 billion of assets purchases and none would have been sold; that inflation would be 0% and that the market implied Bank Rate three years ahead (mid 2018) would be only around 1.6%.

“All this is a sign of the enormous and lasting disruption that came after the financial crisis of late 2008.”

Conditions, however, have started to change and now “the case for beginning a gradual normalisation in the stance of monetary policy is stronger than at any time since I joined the committee over 6 years ago.” Having been called an “arch-dove” in the past some might think it “bizarre” for David to say this. But, he says, “they should not; the ‘hawk – dove’ labels are pretty silly because they suggest some unchanging genetic tendency towards favouring one type of policy; anyone who was like that would be very ill suited to be on the MPC.”

Dealing with the aftermath of the financial crisis has proved exceptionally hard, but there are lessons we can take from it for both financial stability and monetary policy. First, “the best way to handle the risks of incurring huge costs from another financial crisis is to control leverage in the financial sector”. Since the crisis, policy makers have debated the value of using macro-prudential tools versus interest rates in tackling financial instability. David argues that the UK is going down the right route by increasing capital requirements and reducing leverage in the banking sector rather than “skewing monetary policy towards trying to stop financial instability problems”.

Second, we have learnt more about the dynamics of the effective lower bound (ELB) and the efficacy of QE. When central banks the world over cut interest rates to their ELB many believed that the risks of self- reinforcing deflation and protracted slumps had increased sharply and that asset purchases were not likely to help much. In the end, only a few OECD countries experienced outright deflation and falls in short term inflation expectations were temporary.

Turning to the likely future path of monetary policy, given the current outlook David finds that though “it is not all good news” we are in “a much better place than we have been: unemployment is down to just under 5.5%; annualised GDP growth has been near 3% for several quarters; consumer and business confidence has risen sharply over the past year or so; the household saving rate is low and suggests that spending is not being held back by expectations of low near term inflation; wages are rising; the availability of finance has risen and its cost fallen; corporate profitability looks solid.”

So where might Bank Rate be heading? “That question could be couched in terms of so called r* (the appropriate interest rate to keep inflation on track and demand in line with productive capacity)”. A number of factors might mean that this rate will be “significantly lower than in the past”, four important ones are: increased credit spreads, fiscal headwinds, secular stagnation and demographics. David concludes that the combination of these factors, and their various weights, could lead to a rough estimate of r* three years or so down the road of around 2.5 – 3%, relative to the 4.5 – 5% prior to the crisis. This lower range is “some way north of the conditioning assumption used at the time of the May Inflation report of just under 1.5%.”

“Given that, and given that many of the after effects of the mess of 2008 do seem to have faded (e.g. the drying up of bank credit) then I think a first move up in Bank Rate soon is likely to be right. I do not attach great weight to the idea that starting this process will create great risks of dropping back into very weak growth, falling into negative inflation and engendering a splurge in risk avoiding behaviour. I attach more weight to the risks of waiting too long and then not being able to take a gradual path to a more normal stance for monetary policy.” David adds, “one thing the MPC will not do (and never has) is just follow another big central bank; it is a daft idea that we cannot raise rates in the UK before the US and also cannot be long behind them.
“As conditions change you change your view on what is right; and things have changed a lot in the UK in the past year or so and very largely for the better. Now is closer to the right time to start a gentle amble back towards a more normal setting for monetary policy…”

Are Interest Rates Stuck At Historic Lows?

In a speech at the Open University, The Bank of England’s Chief Economist, Andy Haldane explores why interest rates in advanced economies have got “stuck” and how policymakers should respond. Highly relevant given the recent BIS report which said there was too much reliance on risky low interest rate monetary policy.

Official interest rates in the major economies remain stuck at unprecedentedly low levels. Central banks have made vigorous attempts to dislodge them, including through special liquidity schemes, asset purchases and forward guidance. Yet interest rates remain stuck. This stickiness in interest rates has surprised both policymakers and financial markets. After they hit their floor, financial markets expected official rates in the US to unstick in 6 months, in the UK in 10 months, in Japan in 13 months and in the euro-area in 14 months. But they have remained stuck: in Japan for over 20 years and in the US, the UK and the euro-area for over 6 years. Indeed, the expected time to lift-off remains as many months away today as when rates first hit their floor: in the US 9 months, in the UK 10 months, in the euro-area 34 months, in Japan 72 months. In Australia, rates are as low as they have been in living memory, and some advocate further cuts still.

Andy explores two possible factors that may have contributed to current low levels of interest rates: “dread risk and recession risk. The first generates an elevated perception of risk, the second an asymmetric balance of risk. Both are relevant to explaining the path of interest rates, the likely fortunes of the economy and the optimal setting of monetary policy.”

The effects of dread risk have, Andy argues, “proved lasting and durable.” The fear of a further financial crisis and the risk-averse behaviours that follow help “explain the sluggishness of the recovery, and the adhesiveness of interest rates, since the crisis.” And, “if the past is any guide, these scars may heal only slowly.”

In a discussion of recession risk, Andy considers what we can expect for future growth on the basis of past trends. He finds that “the probability of an expansion lasting for longer than 10 years is, on past evidence, less than 10%.”

“If a recession were to strike in the period ahead, a relevant question for monetary policy is how much room for manoeuvre might be necessary to cushion its effects.” Comparing the magnitude of previous loosening cycles to the current path of the yield curve Andy finds, “recession probabilities exceed interest rate threshold probabilities by a factor of anywhere between 1.5 and 4.”

“Put differently, based on these estimates there is a considerably greater chance of interest rates needing to be cut to their floor to meet recessionary needs than of them gliding back to levels that could safely cushion a recession. Even after interest rates have lifted off from their floor, it is more likely than not they may return there over a ten-year horizon.”

What, therefore, are implications for monetary policy of continued dread and recession risk? Using the forecast from the May Inflation Report Andy has updated the interest rate trajectories he produced earlier this year. “As then, they suggest the optimal path for interest rates involves an immediate cut in rates for about a year, which pushes inflation back to target and closes the output gap. Thereafter, interest rates rise gradually in line with the market curve.”

However, the trajectories are illustrative and may “underplay the effects of risk” such as the dread risk and recession risk he has focused on here. He argues these risks have led to a cautious response to the recovery by both households and, to some extent, businesses which may “skew growth risks to the downside”. As a result, while April’s wage data was “encouraging news… one swallow does not a summer make.” “Wage growth is causing some fluttering, but not in this dovecote.”

This, in combination, with the downside risk to the MPC meeting its 2% inflation target two years hence, gives Andy “considerable sympathy” with the argument that interest rates should be “lower for longer” to manage the risks from raising rates too soon. A rate rise “however modest” would be a further example of bad news to already cautious consumers: “A policy of early lift-off could be self-defeating. It would risk generating the very recession today it was seeking to insure against tomorrow.”

This leads Andy to conclude: “my judgement on the appropriate monetary stance in the UK is relatively little altered from earlier in the year. The current level of interest rates remains, in my view, appropriate to assure the on-going recovery and to insure against potential downside risks to demand and inflation. Looking ahead, I have no bias on either the size or direction of future interest rate moves.”

When, Why, and What’s Next for Low Inflation?

A significant speech from the Bank of England by External MPC member Kristin Forbes “When, why, and what’s next for low inflation?: No magic slippers needed“.

Kristin Forbes explained why she is confident that inflation is currently “on track to rebound toward target” by early 2016. And unlike the solution to deflation proposed in the Wizard of Oz, the UK’s rebound will not require “assistance from wizards or magic slippers”.

Kristin opens by noting the “remarkable shift” in most developed countries; from inflation “too high” in the 1970s, to “just right” in the 1990s to mid-2000s, to falling to levels that raise concerns about being “too low” over the last few months.
Kristin then considers several concerns that have been raised about current low inflation and finds some “overhyped” and others worthy of close attention. The first of these is the claims that consumers and businesses could delay purchases and investment if they expect items to be cheaper in the future. Kristin finds this argument “unconvincing for the UK today”. Instead the evidence suggests that “consumers tend to spend more – not less – on items whose prices fall”.

Likewise the claim that low inflation will make it harder for individuals, businesses and governments to repay debt “have some merit” but are not applicable today; “interest rates are near historically low levels, credit is readily available for most credit-worthy borrowers, debt-servicing ratios are relatively low, and low inflation is expected to be short lived.”

A more significant concern is that the current low level of inflation will have persistent second-round effects by lowering inflation expectations which could in turn supress wage growth. This is something for the MPC to watch closely but “there is not yet any evidence that low inflation has significantly held back wage growth. Instead, wage growth has picked up over the period that inflation has fallen.” In fact, “the rapid normalization of the labour market should continue to support wage increases – even in an environment with low headline inflation”.

Kristin dedicates most of her analysis to the final concern; that “low rates of global inflation, or just low inflation in individual countries with strong links to the UK, could create additional spillover effects that drag on UK prices”. An unusually large number of countries are currently experiencing deflation or low inflation, and there is a risk that the UK could be exposed to weak prices abroad through its significant export and import markets or even “latent competitive effects”.

The recent downward movement in core inflation, however, seems to be driven more by sterling’s 18% appreciation than by any spillover effects from low inflation in other countries. Kristin confirms this by introducing an expanded set of measures of domestically-generated inflation, which show remarkable stability in domestic inflation over the last year, after removing the effects of exchange rate movements – and even upward movement in wages and unit labour costs. A detailed analysis of the effects of inflation in other countries finds that “inflation in some of the UK’s more important trading partners (such as Germany) may have some small additional effects on UK inflation rates. But inflation in many economies with strong ties to the UK – whether through location, colonial linkages, language, or other variables – does not exert any significant effect on UK inflation. Even key trading partners’ inflation rates do not seem to generate any consistent and significant spill-overs to UK core inflation rates.” Therefore, low inflation elsewhere seems unlikely to cause low-inflation to persist for longer than currently expected.

All of which leads Kristin to conclude that “inflation is currently on track to rebound toward target without any need for assistance from wizards or magic slippers.”

Governor Mark Carney speaks at the Mansion House on 10 June 2015

Bank of England Governor Mark Carney makes a major speech at the Mansion House on 10 June 2015, with Chancellor George Osborne, and Lord Mayor Alan Yarrow. Governor Carney details the reforms that the Fair and Effective Markets Review will bring to ensure real markets and financial services that serve society, free of implicit public subsidy. In the speech, he details reforms under way to market-structures, standards, systems, incentives, training, etc, and outlines the work of the Markets Standards Board. The UK’s global reputation will, he says, be enhanced by the strong reforms under way, which will include individuals taking clear personal accountability for wrongdoing. He also details earlier failings of the Bank of England – as well as its successes.

A transcript of the speech is available.

What The UK Regulators Are Focussing On Next

Donald Kohn, External Member of the Financial Policy Committee, Bank of England, addressed the Society of Business Economists giving views on some broad priorities for the FPC in coming years. First, how the FPC can continue to build a systematic and disciplined approach to macroprudential policy – to identifying risks and using our powers of direction and recommendation to address them; and second, how the FPC can contribute to fostering safe and resilient market alternatives to bank finance in the UK.

I have been a member of the Committee since its inception as the interim FPC in the spring of 2011. In that time I believe we have accomplished much to make the UK financial system safer and put in place the foundations for continuing that work in the future. We have worked with the Prudential Regulation Authority (PRA) to build the resilience of the UK banking system – especially to build its capital cushion against future shocks – so that it can continue to deliver financial services to the real economy in the face of adverse economic and financial developments, and without requiring further taxpayer support. To this end, we phased in the Basel 3 capital risk-weighted capital requirements as quickly as possible for UK banks and instituted a minimum leverage ratio; there is still some work to be done, but major UK banks are now comfortably ahead of the Basel 3 transition timetable. Greater capital supports growth not only by making crises less likely and less severe, but also because well-capitalized banks have been shown to be more willing to lend.

Last year the FPC and the PRA initiated concurrent capital stress tests across large UK banks and are making these tests a regular part of the capital framework. This was a major innovation and strengthens our ability to be explicit about what we see as the important risks to financial stability in the UK and to test the banks’ resilience to those risks. Last year we tested banks’ resilience against the effects of a substantial rise in UK interest rates and a fall in property prices; this year our stress scenario originates in a major shortfall in growth in the rest of the world. The horizontal comparisons across banks from these tests can be particularly revealing about the relative capital positions, modelling characteristics, and risk management capabilities of each major UK bank.

These tests also importantly increase transparency to the public about the FPC’s view of risks to financial stability, the individual bank’s ability to withstand those risks, and the actions the FPC and PRA are taking in response to the results. In that regard the stress tests are an important new element in the accountability of the FPC and the PRA. I expect the stress test to play a major role in our execution of macroprudential policy in the future and I expect us to continue to develop our ability to use the information we collect to identify threats to financial stability, such as procyclicality of bank risk models, interconnections among banks that may not be evident on the surface, and crowded and correlated positions that make the system vulnerable to particular asset price movements.

The FPC has also identified various risks to financial stability beyond those posed by potential bank credit losses and made recommendations to deal with them. For example, we highlighted the dangers of cyber attack, and the potential for rising house prices to cause borrowers to become so indebted for the purchase of houses such that they would need to cut back sharply on spending should interest rates spike unexpectedly or income be temporarily depressed. In both cases we made recommendations that were implemented to counter the perceived risks. And we worked with the banks to enhance their disclosures and thereby strengthen the ability of their private sector counterparties to monitor and price the riskiness of banks through greater bank transparency – especially around capital risk calculations.

Finally we have put in place much of the basic framework required to operate macroprudential policy on an ongoing basis. We worked with HM Treasury and Parliament to get authority for the tools we need – including powers of direction over capital, leverage and key terms of lending against residential real estate. And we issued policy statements outlining how we might use these powers of direction to sustain financial stability.

As a Committee, we have established good working relationships with the PRA, the Financial Conduct Authority (FCA) and the Monetary Policy Committee (MPC). Macroprudential policy is implemented mostly through the PRA and FCA and they and we need to have a good understanding of what each authority is trying to accomplish and how our actions affect the objectives of the others. The chief executives of the PRA and FCA are both members of the FPC and have provided guidance on how to shape our recommendations to accomplish our objectives. Both macroprudential and monetary policy seek to accomplish their separate objectives by affecting aspects of financial conditions, so it is critical that each committee understand what and how the other intends to operate and can weigh the implications for meeting its objectives. The FPC has been asked to provide an independent voice on financial stability – by the MPC and by Treasury (in help-to-buy) to assess the financial stability implications of their policies. We are not completely finished with establishing the macroprudential framework: we need to complete the capital framework; we have requested powers of direction for buy-to-let lending; and the FPC will always need to be alert to the possibility that preserving financial stability in an evolving financial landscape could require new tools in new areas. But I believe the basic structure is largely in place.

Going forward we will be placing more emphasis on how we use the structure; it is a time of transition for the FPC. Having just begun a new three-year term with the FPC, I would like to use this occasion to look forward, to reflect now on what I hope we can accomplish in the next three years, building on the approach already in place. I will concentrate on two broad challenges: first, how the FPC can continue to build a systematic and disciplined approach to macroprudential policy – to identifying risks and using our powers of direction and recommendation to address them; and second, how the FPC can contribute to fostering safe and resilient market alternatives to bank finance in the UK.

How Banks Really Work

In a working paper, issued by the Bank of England, they explore the fundamentals of how banks work. The traditional model is that banks are driven by deposit taking, and use these deposits to make loans, so there is a direct link between deposits (and their volume and interest rates) and capacity to lend. Indeed, some suggest most monetary policy assumes this, yet many central banks have a different perspective. Last year the Bank of England turned the model on its head by suggesting that actually banks have the capacity to create UNLIMITED amounts of credit, in fact creating money, unrelated to deposits.

Banks that create purchasing power can technically do so instantaneously and discontinuously, because the process does not involve physical goods, but rather the creation of money through the simultaneous expansion of both sides of banks’ balance sheets. While money is essential to facilitating purchases and sales of real resources outside the banking system, it is not itself a physical resource, and can be created at near zero cost. The most important limit, especially during the boom periods of financial cycles when all banks simultaneously decide to lend more, is their own assessment of the implications of new lending for their profitability and solvency, rather than external constraints such as loanable funds, or the availability of
central bank reserves. In fact, the quantity of reserves is therefore a consequence, not a cause, of lending and money creation.

This may explain why banking economics work they way they do. It also raises interesting questions in terms of banking regulation.

This paper, “Banks are not intermediaries of loanable funds – and why this matters” – Zoltan Jakab and Michael Kumhof looks at the two models, in some detail.

In the intermediation of loanable funds model of banking, banks accept deposits of pre-existing real resources from savers and then lend them to borrowers. In the real world, banks provide financing through money creation. That is they create deposits of new money through lending, and in doing so are mainly constrained by profitability and solvency considerations. This paper contrasts simple intermediation and financing models of banking. Compared to otherwise identical intermediation models, and following identical shocks, financing models predict changes in bank lending that are far larger, happen much faster, and have much greater effects on the real economy.

Note that working papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee or Financial Policy Committee.

UK Funding For Lending Data Q1 2015 Released

The Bank of England has today published data on the use of the Funding for Lending Scheme (FLS) showing, for each group participating in the FLS Extension, the net quarterly flow of lending to UK small and medium-sized enterprises (SMEs) and non-bank credit providers (NBCPs), and the amount borrowed from the Bank in the first quarter of 2015.

The Bank has today published data on the use of the Funding for Lending Scheme (FLS) showing, for each group participating in the FLS Extension, the net quarterly flow of lending to UK small and medium-sized enterprises (SMEs) and non-bank credit providers (NBCPs), and the amount borrowed from the Bank in the first quarter of 2015.

During the first quarter of 2015, the number of groups participating in the FLS Extension was 34. Of these, 10 participants made drawdowns of £3.1bn in total. Participants also repaid £1.5bn, taking total outstanding drawings to £57.3bn.

Net lending by FLS Extension participants to SMEs was £0.6bn in the first quarter of 2015. This compares with quarterly net lending to SMEs in 2014 Q4 by FLS participants of -£0.8bn, while the quarterly average for 2014 was -£0.5bn

Quarterly net lending to SMEs and NBCPs by FLS Extension participants

Source: Bank of England. (a) For more details of the sector definitions within FLS see the Market Notice. (b) Note that the number of groups participating in the FLS Extension fell to 34 in 2015 Q1, from 38 at end-2014.

A number of institutions expanded their lending in 2015 Q1 and further borrowing allowances of £4.9bn have been generated, spread across 16 participants.

Aggregate net lending to SMEs (i.e. including lending by banks and building societies not participating in the FLS) was also positive in 2015 Q1. This is part of a broader improvement in lending to all non-financial businesses, as discussed in the May 2015 Inflation Report.³

Over the past few years, credit conditions have improved for SMEs. This has continued in 2015. According to the FSB Voice of Small Business Index, availability of credit to small businesses has risen in 2015 Q1. And in the Bank’s 2015 Q1 Credit Conditions Survey (CCS), lenders reported that spreads over reference rates for medium-sized companies fell significantly over the quarter. The CCS also reported that spreads were broadly unchanged for smaller companies however, while the Bank’s network of Agents report that some small companies continued to find it difficult to borrow from banks.⁴

The improvement in corporate credit conditions in part reflects the significant fall in bank funding costs that has occurred since the launch of the FLS. Over the first quarter of 2015, the level of funding costs remained low. The FLS Extension will continue to support lending to SMEs in 2015.

UK banks’ indicative longer-term funding spreads

Sources: Bank of England, Bloomberg, Markit Group Limited and Bank calculations. (a) Constant-maturity unweighted average of secondary market spreads to swaps for the major UK lenders’ five-year euro senior unsecured bonds, or, where not available, a suitable proxy. (b) Unweighted average of the five-year senior CDS premia for the major UK lenders. (c) Sterling only, average of two and three-year spreads on retail bonds. Spreads over relevant end-month swap rates. Constant-maturity unweighted average of secondary market spreads to swaps for the major UK lenders’ five-year euro-denominated covered bonds, or, where not available, a suitable proxy.

The Future Shape of Banking Regulation

In a speech entitled “The fence and the pendulum“, by Martin Taylor, External Member of the Financial Policy Committee, Bank of England, he discusses the thorny problems of macroprudential policymaking, which very much include the bank capital and too-big-to-fail agenda. It is worth reading in full.

He concludes:

This is a crucial time for the new international order in bank regulation. We are close to agreement on new standards that the industry, in the UK at least, is not too far off meeting. Four years ago that would have seemed a highly desirable outcome but quite an unlikely one. It’s good for our economies, and it will turn out to be good for the financial industry over the next quarter-century. At the same time the emergence – well, they never went away – the increasingly shrill emergence of voices calling for a regulatory softening is both structurally wrong and conjuncturally wrong. It remains the ungrateful job of the supervisors to save the banks from themselves. The shortness of human memory span and the speed with which we forget the ghastly misjudgements of the recent past: these are the enemies, the unresting enemies, alas, of financial stability.

Oil Prices And Their Economic Impact

How will lower oil prices flow through into inflation, growth and economic activity? Will monetary policy need to adjust to take account of oil price movements, or should these short term movements be isolated from inflation targetting? All important questions.

In a speech given today to the AIECE Conference in London, Martin Weale, External member of the Monetary Policy Committee, discusses two key issues for the inflation outlook in the UK: the impact of oil price moves on the UK inflation forecast, and the degree to which international prices feed through into the outlook in this country.

Weale’s arguments derive from models he believes offer a more realistic sense of the probability of relatively extreme movements in prices occurring than implied by more popular methods in economics – a lesson economists should have learned from the financial crisis. He states: “It might seem like a technical point, [but] it is in fact fundamental: if you seriously underplay the chance of relatively extreme events happening, then not only will you be more surprised when they do happen, but you may be tempted to read too much into them.”

Weale’s model for the impact of oil prices on the macroeconomy – drawing on long run data beginning in 1970 – indicates there is a risk that the impact of the oil price fall we have witnessed will be somewhat stronger in the near term than the MPC has predicted. The result, he concludes, would be that growth for 2015 would prove a little stronger, and inflation a little weaker, than expected.

However, Weale states that the risk of a slightly weaker profile for inflation has little impact on his outlook for policy, as the effect will have dissipated within two years – the relevant point for policymaking.

Turning to the international context, Weale investigates how far inflation in the UK is determined independently of what happens in other advanced economies.

Weale notes that the correlation between inflation in the UK and other OECD countries has been relatively high since 2008 – and more so over the past eighteen months.

However, he finds that there is relatively limited statistical evidence that the correlation is strong over the longer-run. Using data from 1993 to the present, he notes that the variability of core inflation in other rich countries can account for only about a seventh of the variability of UK core inflation.

Summing up, Weale states that the MPC must weigh the need to respond to these international factors, against the desire to provide some stability in the level of interest rates and output.

He adds: “I think the Committee is quite right to let the short-term effects of external shocks feed into inflation, even if this pushes it far from target, whether on the downside as now, or on the upside as in the crisis. To do otherwise, and tighten or loosen aggressively, would do little to help inflation in the short term, but would risk a lot with unwanted gyrations in output.”