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

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 mis