However, during the period of turmoil since last summer it has proved toxic, here and overseas, for banks to access liquidity on those terms from central banks unless in broad and quality company. That has created uncertainty about the access of banks to the central banks in practice, and has required innovation and clear assurances from the central banking community. This alone will require reforms to the way in which central banks use their balance sheets, and money creating power, to sustain financial stability. Banks will also need to adapt. It seems that at not a few firms, the discipline of risk management somehow got separated from that of balance sheet management (or funding). It was effectively assumed that financing markets would remain open come what may. There is a question of whether treasury management should somehow be insulated from the pressures of a profit centre. Separately, assumptions were made about relationships between asset prices that have proved groundless. One such is the spread between term money market rates and expected central bank policy rates. So long as the so-called LIBOR/Overnight Index Swap spread was narrow at all maturities, few market participants cared about whether they hedged against a LIBOR-based instrument when in fact sometimes they really needed a hedge relative to a risk-free rate. We sense that some international fixed-income asset managers would like there to be OIS-based contracts alongside LIBOR-based financial contracts, so that they can tailor their hedges more precisely.
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 we implement this strategy successfully, we will be able to provide more durable support for demand and activity. If, by contrast, we were to adopt a course that let the inflation genie out of the bottle, we would find ourselves needing to tighten policy, exacerbating the slowdown in activity. That broad strategy is not a recipe for inaction.