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  1  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). BIS Review 84/2007  3  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 year to over 3000 basis points. Each of these steps has left casualties.
Our knowledge is neither complete nor constant. At the other end of the spectrum, rational optimising behaviour can, in principle, generate a policy reaction function which takes into account uncertainty about the economy and the process of learning about economic relationships. Such a reaction function would describe how a central bank would respond to any conceivable shock in the future, and explain how estimates of parameter values and the weights attached to particular models would be updated. But even in very simple examples the cleverest economists find the solution of those decision problems almost impossibly complicated. Fully rational optimising behaviour is unreasonably demanding. In the words of Gerd Gigerenzer (2001), optimisation is for “Laplacean demons” not human beings – a reference to an imaginary being that “…could condense into a single formula the movement of the greatest bodies of the universe and that of the lightest atom…”10 Both approaches, for very different reasons, end up with a monetary policy rule. The simple rule is not credible because we do know some things and we can learn from the past. The complicated rule is not feasible because it places unrealistic demands on our ability to process information. Given the lack of further guidance from economists as to how to make decisions, central banks have often retreated to the position that setting interest rates requires the exercise of unfettered discretion. But this has problems of its own.