Paul Tucker: Monetary policy and the financial system
Remarks by Mr Paul Tucker, Executive Director and Member of the Monetary Policy
Committee of the Bank of England, at the Institutional Money Market Funds Association
Annual Dinner, London, 2 April 2008.
* * *
Alongside many others, the money market fund industry has for months now been grappling
with turmoil and fragility across financial markets. It continues to pose serious challenges for
all of us, and so I shall use this evening to summarise briefly a few of the strands in my own
thinking about monetary policy and the financial system.
Monetary policy
First, monetary policy. The tightening of credit conditions domestically and internationally
makes it likely that aggregate demand will slow, with a risk that it will slow considerably.
There is, in consequence, a meaningful downwards threat to inflation over the medium term.
Usually, the MPC would respond by cutting Bank Rate sufficiently to offset more or less
entirely what we judged, over time, to be the impact of the tighter financial conditions on the
path of spending, so as to ensure that aggregate demand remained broadly in line with the
economy's productive capacity. But conditions do not favour such a "business as usual"
approach to demand management. That is because, alongside those downside risks to
inflation, there are also upside risks to inflation over the medium term - and I am stressing
"medium term" - stemming from the rise in commodity prices and the decline in sterling's
exchange rate. In the near term, CPI inflation is very likely to rise to materially above our 2%
target. The question is whether that unavoidable temporary rise will remain just that,
temporary; or whether it will feed into medium-term expectations of inflation, and so get
reflected in wages and prices going forward and, thus, in domestically-generated inflation.
Given this unusual combination of significant downside and upside risks to the medium-term
inflation outlook, the broad policy strategy is to offset some but not all of the adverse shock to
demand from tighter credit conditions. And to do so by changing Bank Rate gradually and
with transparency about that broad strategy. To be clear, this approach probably means
allowing a degree of slack to develop in the economy, in the interests of avoiding taking risks
with inflation on the upside. Only by underpinning the credibility of the nominal anchor
provided by the MPC's commitment to the inflation target will we maintain scope to cushion
the real economy from the effects of the stresses in the international financial system. If we
implement this strategy successfully, we will be able to provide more durable support for
demand and activity.
If, by contrast, we were to adopt a course that let the inflation genie out of the bottle, we
would find ourselves needing to tighten policy, exacerbating the slowdown in activity.
That broad strategy is not a recipe for inaction. The central projection in February's Inflation
Report was for inflation to return to close to the 2% target over the coming two to three years,
conditional on the market's expectation of further cuts in Bank Rate. But nor does the
strategy determine a definite path for Bank Rate over the coming months. Each of us on the
MPC must form a judgment month by month on which of the risks to the inflation outlook -
from financial conditions or from rising costs - is proving more potent, and so a judgment on
the degree to which we can set a course that underpins demand.
Since the February Inflation Report, oil prices are around 10% higher, and sterling's
exchange rate around 4% lower, so the immediate cost pressures are worse. The good news
is that, in the labour market, nominal earnings growth has so far remained subdued,
notwithstanding the rise in near-term inflation expectations revealed by a range of surveys.
This is perhaps suggestive of the adjustment in real take-home pay made necessary by the
sharp increase in firms' costs due to the further rises in commodity prices. In manufacturing,
firms' input costs have risen sharply over the past twelve months; and output price inflation
has reached nearly 6%. A big question is to what extent competition amongst retailers will
dampen the pass through into retail prices. Anecdotally, retailers still sound as though they
are competing fiercely on prices, and driving down other costs in order to maintain their
margins.
Meanwhile, on the other side of the ledger, many essentially backward-looking indicators of
UK real demand and activity have held up reasonably well. But we should not yet place great
weight on that. It can sometimes take time for disturbances to affect real economic activity. In
the United States, arguably there was quite a lag between the onset of problems in housing
finance and the pass through to spending. The UK looks to be quite a lot better than the US.
The latest data for Q4 last year did, however, suggest that household spending on durables
slowed quite significantly. And we are seeing softening in consumer confidence and property
market conditions. So the picture on the real economy is mixed.
What is clear is that credit conditions are unambiguously tighter than two months ago,
underlining that source of downside risk to the outlook for demand and inflation. In retail
lending markets, banks have raised the interest rates charged (relative to Bank Rate) on new
lending, but they have all been doing much the same and many borrowers seem to have
been willing to pay the extra. In consequence, banks generally may not have achieved their
desired conservation of balance sheet capacity, and we are now seeing the withdrawal of
some lending products.
And in wholesale markets, the spread between the price that the banks themselves pay for
funds, roughly LIBOR, and the expected central bank policy rate has, again, widened
significantly over the past couple of months across the major international markets. Many
financial contracts are linked closely to three-month LIBOR so, other things being equal, the
increase in money market spreads has the effect of reducing the level of Bank Rate
consistent with unchanged monetary conditions.
At the Committee's March meeting, I judged that an immediate further cut, following
February's, might very easily have been misunderstood as a change of strategy away from
the one focused on the medium-term outlook for inflation that I have spelled out this evening.
My own vote at the April meeting will depend on all the data, some of it still to reach us, since
then.
Financial system deleveraging: legacy portfolios
Whatever path monetary policy takes in the UK in the months ahead, it is clear that the
process of deleveraging in the financial system is not complete. Some asset prices embody a
hefty discount for the current illiquidity in markets, which feeds into the accounting measure
of financial firms' capitalisation, and so into perceptions of counterparty credit risk and money
market conditions. In consequence, there remains a risk that credit creation - the lubricant
that the financial system provides to the real economy - will be further impaired. Several
features of our financial system lie behind this, and I want to touch on just a few of them.
Financial markets have swung from a prolonged period of underpricing risk to now plausibly
overpricing risk on at least some products. And yet, one might think perversely, we have also
swung from an over abundant supply of credit to a much more restrictive supply of new
credit. The global insurance industry provides an interesting contrast with banking in this
respect. For sure, it too is capable of systematically misjudging risks. But when a shift in risk
appreciation and pricing occurs, the reinsurance industry often separates the run off of old
portfolios containing mispriced contracts from the establishment of new vehicles, capitalised
separately to take advantage of attractive terms on new business. And for regular insurance,
many contracts are annual, so adversely priced business can run off fairly quickly. Banking
typically works quite differently. Banks around the world are carrying portfolios of term loans
that are the legacy of the boom years. There is uncertainty - amongst banks' management,
shareholders and funders - about the degree of fundamental impairment in those portfolios.
New loans are booked to the same balance sheets. And so many banks face a choice
between, on the one hand, conserving capital and liquidity to support legacy portfolios; and,
on the other hand, deploying capital and liquidity to write new business on what some see as
the attractive terms and conditions now available. The banking system simply is not
structured routinely to insulate new business from the legacy of past mistakes; funding and
capital are fungible.
This predicament may be exacerbated by other features of the current environment.
One is an apparent reluctance on the part of banks to raise fresh capital except where the
market thinks that it is beyond doubt that they need to do so. Given the feedback from credit
conditions to asset prices and the real economy and so potentially to banks' future earnings,
it might seem slightly odd for banks internationally to be maintaining distributions to
shareholders but tightening credit availability in order to preserve resources. This has to be
seen in the wider context.
One possible explanation for banks holding back from raising fresh capital is that they may
want to avoid giving an adverse signal about themselves. If there is a co-ordination problem,
the regulatory authorities internationally should be able to tackle it, allied to ensuring prudent
valuations of legacy portfolios. But another possible explanation is that, like some other
market participants, bankers may believe that many legacy assets are fundamentally
undervalued at present and that the markets for securitised assets will, with time, recover
and reopen. On that view, banks are avoiding becoming overcapitalised on a fundamentals
(or forward looking) basis, and so setting off another expansionary phase in the credit cycle,
a little further down the road. The serious puzzle which that underlines is why there is a
dearth of buyers for the supposedly undervalued paper. With the terms and availability of
financing from banks and dealers having tightened, levered funds are hardly likely to be the
US Cavalry. But it is interesting that there has not been more interest from investment
institutions with ostensibly long holding periods, which are largely unlevered and are not
exposed to liquidity risk from borrowing short and lending long. What we commonly hear
from contacts is that investment managers do not want to be caught out if asset prices fall
further before they recover. But no one can seriously believe that they can spot the bottom of
the market, and short-term horizons should not weigh heavily in longer-term investment
institutions. All of which suggests that there may be structural impediments. Those could
include some combination of the reasonable difficulty that some asset managers experience
in assessing the quality of securitised assets; and mandates and accounting policies that
may have the effect of shortening asset managers' time horizons.
The challenge for your own industry seems to have been slightly different. The managers of
some money funds around the world, although I am sure not all of your members, joined in
the "search for yield" by going down the credit spectrum and increasing maturity mismatch
during the boom in credit markets. As those funds have moved back towards home base,
shortening the maturity and increasing the liquidity of their assets, one effect has been a
reduction in the net supply of term funding into the international banking system.
That has been one of many contributors to the liquidity strains evident in money markets. But
those strains have also been exacerbated by an unexpected breakdown in the technology for
liquidity insurance provided by central banks.
For well over a century, throughout industrialised world there has in effect been something
akin to a Social Contract between the banking system and the authorities. The banking
system is permitted to profit from undertaking leveraged maturity transformation in the course
of intermediating the liquid savings of depositors into illiquid loans to households, firms and
others. In doing so, commercial banks provide liquidity insurance, whether via demand
deposits or committed lines of credit. They can do this because their deposit liabilities are
money, which puts them at the heart of the payments system and is what makes them
special; banks are at the heart of a monetary economy. In return, the authorities respond with
a combination of prudential supervision, to contain the risks that banks run; deposit
insurance, to protect savers; and liquidity insurance from the central bank. Smaller
commercial banks can try to buy liquidity insurance from their larger brethren. Large banks
cannot realistically do the same. But there is no cast iron guarantee that asset markets will
remain liquid in all conditions. So since Bagehot's day, central banks have stood ready to
provide unlimited liquidity against good collateral at a rate that is higher than the normal
market rate. However, during the period of turmoil since last summer it has proved toxic,
here and overseas, for banks to access liquidity on those terms from central banks unless in
broad and quality company. That has created uncertainty about the access of banks to the
central banks in practice, and has required innovation and clear assurances from the central
banking community. This alone will require reforms to the way in which central banks use
their balance sheets, and money creating power, to sustain financial stability.
Banks will also need to adapt. It seems that at not a few firms, the discipline of risk
management somehow got separated from that of balance sheet management (or funding).
It was effectively assumed that financing markets would remain open come what may. There
is a question of whether treasury management should somehow be insulated from the
pressures of a profit centre. Separately, assumptions were made about relationships
between asset prices that have proved groundless. One such is the spread between term
money market rates and expected central bank policy rates. So long as the so-called
LIBOR/Overnight Index Swap spread was narrow at all maturities, few market participants
cared about whether they hedged against a LIBOR-based instrument when in fact
sometimes they really needed a hedge relative to a risk-free rate. We sense that some
international fixed-income asset managers would like there to be OIS-based contracts
alongside LIBOR-based financial contracts, so that they can tailor their hedges more
precisely. There should be wider benefits from contracts based purely on the risk-free rate
rather than embodying liquidity premia and credit-risk premia of various kinds. That is
something for the industry.
But better liquidity-insurance technology and better risk management will not abolish the
credit cycle. Looking further ahead, the big question will be whether the authorities can tame
the credit cycle without sacrificing the incentives to enterprise that are so important in a
dynamic economy. The debate about the micro regulation of banks will need to take account
of whether or not we can deliver that macroprudential objective. For too long, the debate has
got sidetracked. Into whether we can rely on monetary policy "mopping up" after bubbles
burst. Or into whether monetary policy could be used to control asset prices as well as doing
its orthodox job of steering nominal trends in the economy, which I should say can include
taking account of prospective risks of inflation volatility over the medium term. Ideas
circulating already include minimum margin requirements or capital ratios that vary not only
across firms but also through time as credit conditions change. We need calmly to explore
whether there are also other possibilities. But let me make this absolutely clear: there are
formidable obstacles to finding a solution. In the monetary sphere, a regime of floating
exchange rates allows individual countries to pursue their own domestic monetary objectives.
But in a world in which capital flows freely, local attempts to control the pace of credit
creation, particularly within the financial system, may not work. All of that will need to be
thought through. But first we need to concentrate on the immediate challenges.
Summary
In a speech four months ago, I stressed that "we must try to avoid a vicious circle in which
tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit
supply, and slower aggregate demand feed back on each other". I identified monetary policy,
liquidity policy, and regulatory capital policy as being amongst the instruments the authorities
would need to use. That remains the case, as the stress in the global financial system has
continued and, in the US at least, evidence of a feedback loop is apparent. Each of those
instruments is constrained in some degree. That underlines the need for close co-operation
between the authorities and the industry, and internationally.