(e) Market-Based Finance: The emergence of a large and diverse shadow banking system, both prior to the crisis in the US and subsequent to it elsewhere around the world, plainly poses both considerable opportunities and potential threats to financial stability. So-called market-based finance provides the financial system with a second, non-bank, engine on which to fly which could be beneficial in a diversity 27  For example, the results of the Bank of England’s 2014 stress test found that risk-weight procyclicality was a significant contributor to the change in capital ratios in the stress test scenario (Bank of England (2014)). 37  All speeches are available online at www.bankofengland.co.uk/speeches  37  sense. Nonetheless, it also gives rise to potentially new sources of systemic risk and contagion, as risks change shape and location. The FSB has made significant progress in progressing the regulatory debate on such matters (FSB (2017e)). Certainly, these trends carry implications for both the conduct of regulation and for central bank procedures. A world of greater market and liquidity risk may call for different sets of regulatory instrument than the bank-based solvency and liquidity metrics of Basel III. Market-based instruments, such as margin requirements, may have a greater role to play (see, for example, ESRB (2017)). It may also call for different types of market intervention by central banks – different markets, different instruments, different counterparties. The crisis has already seen a mini-revolution in the design of liquidity facilities by central banks.
The economy has also faced significant cost shocks in the past couple of years, this time in a negative direction. Commodity prices have fallen sharply, sterling’s exchange rate has risen. The combined impact has been enough to push CPI inflation down to zero. We don’t face the same trade-offs as during the 2009-12 period, as output now looks much closer to potential. Equally, there is a good argument for “looking through” some of the effects of these cost shocks. Faced with the same situation, Committee A would probably choose to loosen policy now in order to get inflation back to target as rapidly as possible. But, with the output gap projected to narrow further anyway, and because the effects of lower commodity and import prices are likely to fade over time, it would probably then face the prospect of having to re-tighten policy thereafter, as inflation threatened to move above the target. There was a very slight flavour of this in the MPC’s latest projections. The Committee has said it wants to get inflation back to target in “around two years and [keep] it there in the absence of further shocks”. Given all the other underlying assumptions in the forecast, the yield curve we faced at the time broadly does the first part of that job. But the central forecast rises a touch above target at two years and then drifts a little higher. For what it’s worth, and if only at the margin, that yield curve was thought likely to over-achieve.