rachel lomax : current monetary policy issues speech by ms rachel lomax, deputy governor of the bank of england, to the hull & humber chamber of commerce, hull, 22 november 2007. i am very grateful to gareth ramsay for his help in preparing this speech, and to several other colleagues at the bank of england for useful comments. * * * tonight i want to talk about the current issues confronting the monetary policy committee. it ’ s hard to tell the story of an economy as open as the uk without starting with global developments. that ’ s not a point i need to labour here in hull, the gateway to europe, and home to a brand new world trade centre. and it ’ s never been more true than today. the past 4 years have seen the fastest growth in the world economy since the early 1970s 1. but even more striking than its pace has been the change in the balance of global growth, with emerging economies contributing nearly three quarters of the increase in world output 2. this has become even more pronounced over the past year, as chinese growth has picked up even as the us economy has slowed. the world ’ s economic see - saw has tilted. that ’ s the new reality behind two dramas that have held the world ’ s attention since last august : the turmoil in financial markets ; and the renewed surge in energy prices. both these developments are highly unusual and very recent. no - one knows how they will play out. so you would be right to take all forecasts – including our own – with a large pinch of salt. but the mpc has to take a view, when it sets interest rates. my aim tonight will be to share some of that thinking with you. financial market developments let me start with the problems in global financial markets. over the course of the summer, growing arrears in the us sub prime mortgage market triggered a global loss of confidence in the valuation of securities backed by bundles of mortgages and other loans. how could a relatively limited problem – confined to the bottom end of the us housing market – spark a global financial crisis? it ’ s a good question. the short answer goes as follows. investors had come to rely too heavily on the ability of rating agencies to value what had become exceedingly complex financial instruments. the realisation that their faith had been misplaced cast doubt on the value of a wider class of asset backed securities. many of these were embedded in ever more complex, highly leveraged, investment vehicles. this

the increasing difficulty in modelling and forecasting inflation, see “ issues in inflation ”, global macro issues, deutsche bank, march 2011. bis central bankers ’ speeches relationship is still very difficult, given our current level of understanding of the market linkages. looking ahead we need to realise that macroeconomics will remain inextricably linked to financial market conditions. consequently our economic surveillance will need to focus on the macro - financial and macroeconomic interactions to a much greater extent than in the past. as the crisis demonstrated, sometimes these interactions can be quite complex. domestic economic surveillance in the domestic macroeconomic arena we have learnt other lessons from the crisis. the crisis challenged traditional economic forecasting, especially model - based forecasts. for example, the lack of factors such as balance sheet positions, financing or credit constraints in many simple models of consumption based on a single representative agent has proved unsatisfactory in the post - crisis environment. as a result, we have had to learn about householders ’ new attitudes to consumption and saving as they focus on “ deleveraging ” and rebuilding savings. in this new environment there has been much greater attention to modelling the behaviour of different types of consumers, with differing asset holdings, access to finance and risk attitudes. this has led to the development of new types of models which allow for this heterogeneity. an example of this has been the recent focus in the economics literature on “ agent - based ” computational modelling. 7 it has also led to greater reliance on alternative data sources such as household balance sheets and more up - to - date indicators of spending such as that provided by electronic measures of payments. there has also been greater attention to micro - level survey datasets to obtain information about individuals ’ consumption and saving behaviour. of course, these more detailed data present new challenges in terms of identifying signals from noisier data. as a result, a range of new technical tools will be needed to filter and synthesise the data from these new sources. 8 a further lesson for future economic surveillance, is the increased prominence that credit flows and asset prices may play in policy analysis. in contrast to the pre - crisis consensus view that it is difficult to identify an incipient asset bubble, let alone prick it, most central banks today are putting a lot of effort into monitoring the housing sector, household balance sheets and other assets in an attempt to do just that. before the crisis, monetary policy setting was often characterised as being represented by some form