in the dollar over recent months which should tend to reduce the risk of a sudden correction of global imbalances, another of the key vulnerabilities we have been monitoring in recent years. but the story of the sub prime market is not yet over and it certainly does point to some vulnerabilities in modern financial markets which need to be factored into financial firms ’ risk management. first, this was a layered market in which many originators had an incentive to maximise volumes, where the loans were then securitised and the securities were in turn combined into cdos for onward distribution. one risk in such markets is that there is a loss of information along the chain and that incentives become misaligned ; in particular the quality of credit monitoring and credit assessment declines. it is difficult to avoid the conclusion that occurred in 2006 in the sub prime markets. chart 6 shows the arrears on successive tranches of loans and shows that the quality declined over time particularly in 2005 and 2006. second, the new derivatives markets change the way in which credit losses hit balance sheets. in the world of on - balance - sheet lending, when defaults begin to turn up, there can be scope for rescheduling and for discussing with your accountants what provisions are prudent. we saw that impact on a few of the big banks earlier this year. in the securitised markets, the pace can look slower to begin with but then comes in a rush. chart 7 shows the spreads on different tranches of the abx index, the main benchmark index for sub prime securities. what is remarkable here first is how slow the spreads were to move at all. of course, the predicted losses on particular tranches do no move smoothly with rising defaults, but throughout 2006 the economic press was a buzz with worry about the us housing in particular, the high - grade structured credit enhanced leverage fund and the higfh - grade structured credit fund both managed by bear stearns asset management ( bsam ). market ; sentiment changed several times on whether the housing downturn would lead to a general recession. throughout this period the originators continued to write new sub prime loans and the prices of the abx scarcely quivered. but since january the story has been quite different with two dramatic hikes in the spreads first of bbb and then of the a - rated index. in total, the spread for bbb has gone from 500 basis points at the turn of the

##icating matters at the moment. conclusion the old chinese curse – “ may he live in interesting times ” – might be designed for central bankers. our job is to keep things stable and boring. but there are limits in a rapidly changing world to what is possible. my argument is that the uncertainties today are a return to normality after two years of exceptional predictability in monetary policy both in the uk and elsewhere. a particular area of uncertainty at present is in the credit markets. the dangers of combining a traditional credit cycle with the new derivatives markets have emerged in the us sub prime sector. the us housing market is in its downswing and there are some signs that the same is true in the uk of unsecured credit and commercial property. the position of the bigger uk sectors is less clear cut. the shift in pension fund priorities and the growth of sovereign wealth funds are further clouding the picture. it is our job on the mpc to work through these issues and reach a judgement on them. our target is to reduce inflation to 2 % and keep it there. i can assure you that we will do whatever is needed to achieve that. chart 1 : volatility of gdp and cpi real gdp growth per cent cpi 79 81 83 85 87 89 91 93 95 97 99 01 03 05 chart 2 : gdp and cpi fan charts from may 2006 inflation report chart 3 : corporate bond spreads basis points basis points high yield corporations ( rhs ) emerging markets ( rhs ) investment grade corportations ( lhs ) jan apr jul oct jan apr jul chart 4 : financial market liquidity chart 5 : corporate bond spreads basis points high yield corporations ( rhs ) basis points emerging markets ( rhs ) investment grade corportations ( lhs ) chart 6 : us sub - prime arrears per cent 15 20 25 30 age in months chart 7 : spreads on abx index basis point s bbb - bbb a aug sep oct nov dec jan feb mar apr may jun jul chart 8 : real lbo loan issuance united kingdom united states rest of western europe rest of world us $ billions, 2006 prices 86 88 94 96 06 ( b ) 02 04 chart 9 : corporate bond, leveraged loans and sub - prime markets $ bn us and european leveraged loan markets us sub - prime european sub investment - grade bond us sub investment - grade bond european investment - grade bond us investment - grade bond chart 10 : breakeven inflation forward rates % june mp c 3.