andrew g haldane : haircuts remarks by mr andrew g haldane, executive director, financial stability, of the bank of england and member of the financial policy committee, summarising a forthcoming paper in the journal of monetary economics “ complexity, concentration and contagion ”, 1 august 2011. * * * the views are not necessarily those of the bank of england or the financial policy committee. i would like to thank marnoch aston, benjamin nelson, sujit kapadia, vasileios madouros, priya kothari and andrew mason for comments and contributions. during the summer months, i have my hair cut slightly shorter than during the winter months. this helps keep my head a little cooler in the summer heat and my ears a little warmer in the winter cold. anyone who has seen them will know this is a smart strategy for my ears, to say nothing of my head. this strategy is explicitly counter - cyclical. when the temperature goes up, my hair - length comes down and vice - versa. i am not alone. national statistics show that expenditure on haircuts increases as temperatures rise. the financial system also makes choices about haircuts. the haircuts in question are the amount of collateral a borrower places with the lender over and above the face value of borrowing. but collateral haircuts tend to behave rather differently to personal haircuts. they fall when the financial temperature is increasing and rise when the chill sets in. this strategy is explicitly pro - cyclical. it will tend to result in financial markets being hot - headed in the summer and frozen - eared in the winter. table 1 demonstrates this pattern. it compares haircuts on a range of financial instruments used to back borrowing – so - called securities financing. they are shown on two dates, before ( june 2007 ) and after ( june 2009 ) the financial crisis. haircuts rose by up to 90 percentage points in the space of these two years, as the scorching pre - crisis summer gave way to a frozen crisis winter. in other words, haircuts exhibited a rather dramatic procyclicality over the course of the crisis. table 1 : typical haircut on term securities financing transactions ( per cent ) june 20071 june 20091 medium - term g7 government bonds medium - term us agencies aaa - rated prime mbs asset - backed securities aaa - rated structured products aaa - and aa - rated investment grade

to 13 percentage points. since the “ excess ” inflation relative to the 2 % target is a little over 5 percentage points, that suggests that, in practice, we have ended up accommodating around half the impact of the shocks on inflation. in terms of the outlook, a key issue that the committee faces in deciding the appropriate stance of policy is the extent to which the current elevated levels of inflation will persist into the medium term. our most recent projections, conditioned on market interest rates, existing fiscal plans and the futures prices of commodities, are shown in chart 10. the central view is for inflation is to rise further in the near term as recent commodity price increases pass through, but then to fall back, particularly in 2012 as the rise in vat to 20 % drops out of the twelve - month comparison. it then continues to ease back, reflecting the continuing – though uncertain – drag from the margin of spare capacity in the economy. a number of factors will determine the rapidity of that return to target. profit margins have been squeezed during the recession and businesses are likely to want to rebuild these as the recovery proceeds. but the real purchasing power of wages has also been severely squeezed and employees may also seek to recoup some of that. ultimately this is about how the costs of the recession and the deterioration in the terms of trade associated with higher real import costs are shared out 7, but during the adjustment phase it may be manifested in temporarily higher wage and price inflation. consistently above - target inflation, whatever its cause, may also lead people to believe that it will remain high in the future. that in turn may lead them to set higher wages and prices to compensate and thus to the elevated level of inflation persisting. measures of inflation expectations for the year ahead, for both households and businesses, have moved upwards, though no more than one would expect given the outlook for inflation ( chart 11 ). measures of inflation expectations further ahead, which might be more indicative of a fundamental shift in perceptions of the inflation climate, have though mostly remained well anchored ( chart 12 ). but this is something we are watching closely, in particular for any signs that higher inflation expectations are leading businesses to raise pay and prices. there are elements of all these mechanisms present in our latest projections, but there is a risk that they will turn out to be more powerful than in our central view. and, as noted earlier, there is the risk of further increases in the prices of commodities, especially that of oil