Frankly, it has been shocking over the past year or so to discover how many medium-sized banks and building societies did not hold government bonds or other very high quality assets; or, if they did, how many did not have a regular presence in the gilt repo market or even had no capacity to repo at all. Turning up in the core secured-funding markets for the first time for years is an absolute give away of distress. All that has to change. Market-maker of Last Resort What I have said so far could be mistaken to imply that only banking markets matter. That would be misleading. The capital markets obviously matter too. Indeed, the current crisis has illustrated just what a mess can result from liquidity draining out of those markets. Market liquidity is endogenous: participants thinking that it might dry up can contribute to its doing so. In the early phases of this crisis, by virtue of holding large “trading” books that were marked to market, banks and other traders found themselves having to make very large portfolio write downs in the face of sharp rises in liquidity premia in asset markets. As highly-levered institutions, those mark-downs depleted their net worth to the point of imperilling solvency. That caused a retrenchment in the availability of credit, helping to plunge the world economy into recession, and so impairing the value of more traditional loan books, in a vicious spiral. So it would have been better if, somehow, we could have preserved the liquidity of the markets.
“Letting inflation through”, as it is sometimes called, without taking any measures, is not an option – neither as a policy nor according to the Bank’s mandatory duties. For this reason, the Board of Governors decided yesterday to raise the policy interest rate by 0.75 percentage points. This is a greater increase than in recent decisions and reflects both the exchange rate movements that have taken place and the forecasts for economic developments that the Bank has now presented. No absolute commitment has been given about further policy rate hikes or whether the next steps will be large or small. That will depend on diverse economic events as they unfold. But the tasks assigned to the Bank are clear and it is willing to undertake them. Tight monetary policy may cause a temporary contraction in the economy while a satisfactory balance is restored. It is almost certain that too lax a stance would lead to a disorderly adjustment. Sometimes the economic situation requires the Central Bank to encourage growth and stimulate initiative and enterprise. People see the Bank’s actions then in that same positive light. Then conditions change and the Bank has to change course. Action is needed to counter overexpansion and overheating, and encourage saving, prudence and caution. Then the Bank has to resort to means which may have uncomfortable side-effects. Seen in that light, the Bank’s profile and image appear different. The Central Bank’s ability to use the powers at its disposal as conditions demand must not be changed.