paul tucker : the state of the markets – four issues remarks by mr paul tucker, deputy governor, financial stability, of the bank of england, at the association of british insurers 2009 biennial conference, london, 9 june 2009. * * * many thanks for the invitation to be here today. the bank greatly values its relationship with the insurance industry. we are just immensely grateful for the intelligence you provide, as asset managers and insurers ; and for our constructive dialogue on policy issues. i have a few brief remarks on four broadly linked issues. the macroeconomic outlook and bank lending since the beginning of the year i have felt that it will take until late autumn at least to have any kind of a handle on broadly what type of outlook we face. my view on that hasn ’ t really changed. of course, over recent weeks near - term indicators, notably the business surveys, have improved a bit. confidence seems to have stabilised. and that has been most obvious in the financial markets, where the really good news is that firms on both sides of the atlantic have been raising funds in the equity and bond markets. but a sense of perspective is needed if those apparently small steps forward are not to be frittered away. inevitably the medium - term outlook remains highly uncertain, and the path back to anything like normality can only be gradual i ’ m afraid. in particular, for the moment it is unclear – as, i must say, it is bound to be at this stage – whether the financial system can generate the expansion of credit that will most likely be necessary to support recovery. the reopening of high - grade bond markets has definitely been encouraging. but in most countries, including the uk, bank lending remains subdued. it is hard to disentangle how much of that is down to weak demand, and how much to tighter supply conditions from the banks. i would just say this. i truly believe that it is in the interests of the banks themselves to ensure that businesses get the working - capital finance they need. while one can imagine, i suppose, individual banks being tempted to sit it out in order to deleverage their balance sheets in an environment that is obviously tougher for them, there cannot sensibly be free riders. if all banks were to adopt such a strategy, recovery might end up being anaemic at best, which would feed back into the banking system itself – increasing defaults and depleting banks ’ capital. not lending would

thereby mitigating, once again, the pass - through. so, exporters to the euro area are now able to recoup part of the margins they compressed during the downturn. the extent to which they are able to do so also depends on the degree of competition, a point made by rudi dornbusch back in 1987. the more concentrated market power is, and the less substitutable products are, the more likely firms are to increase their margins following exchange rate appreciations. this also means that the pass - through may well differ across industries. 9 these examples demonstrate that it is by and large the state of the economy that will determine the strength of the pass - through. monetary policy, for its part, is likely to influence the passthrough predominantly through its impact on the economy itself. and at the moment this support from monetary policy may be even more powerful than in the past. the reason is that, in the class of models used here, positive demand shocks are normally identified by assuming that short - term interest rates rise in response to higher growth and inflation. at the current juncture, however, the policy - relevant horizon – the “ medium term ” concept in our monetary policy strategy – is likely to be longer given the persistence of subdued inflationary pressures. our forward guidance on both policy rates and the app, as reiterated by the 6 / 14 bis central bankers'speeches governing council last thursday, reflects this assessment. this means that, compared with past demand shocks, policy will remain more accommodative for longer, thereby likely muting further the pass - through of any growth - driven exchange rate appreciation. and with the current recovery in the euro area being largely driven by domestic demand, euro strength may also have less of an impact on growth than, for example, after the great financial crisis. all of this suggests, therefore, that monetary policy never acts in isolation on the exchange rate and that, in periods of recovery, the positive confidence and stimulus effects of monetary policy are likely to offset, at least in part, the disinflationary effects of a stronger currency coming from expectations of tighter policy. of course, this also means that should the contributions of the different shocks driving the exchange rate change over time, then also our assessment of the impact on inflation will have to change – expansion or not. exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted tightening of financial conditions