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.
Many of the originators were forced into bankruptcy at the start of the year and in the last few weeks we have seen Bear Stearns’ announcement that two of its funds have lost all or nearly all of their investors’ money. I suspect the speed and scale of the changes were outside most stress test simulations. And while the most dramatic changes may have happened there will now be a long period as the implications work through the ratings of other derivatives and the full range of instruments are marked to market. A related lesson is about liquidity in new markets. The worry has been that at times of stress, liquidity would dry up and it would be impossible to trade out of positions. That would not just lock firms into losses but would disrupt strategies which require continuous dynamic hedging – for example, strategies such as constant proportion portfolio insurance (CPPI). Again that has been a feature of recent weeks. It has been widely reported that a couple of the lenders to the BSAM funds put their collateral on the market but were not able to sell as much as they wanted. That is connected to the fourth lesson, the vulnerability of valuations in sophisticated derivatives. These are not widely traded so valuations are usually based not on market prices but on models which draw in turn on correlations established over the recent past. This is a fundamental and unavoidable feature of new products and markets.