This type of crude stress test is quite helpful for a sense of how solid the system’s capital buffer might be, but it doesn’t allow you to take into account second and third round effects. If NPLs have risen to 20 percent of total assets, then there are likely to be a lot of other things happening in the economy at the same time, all of which could have additional implications for banks’ financial soundness. As a result, stress testing is moving increasingly in the direction of scenario analysis. This involves economists constructing scenarios for the outlook on GDP, interest rates etc. and tracing through these changes in terms of their impact on the key measures of banking system soundness including profitability and capital adequacy. This approach involves some quite advanced economic modelling techniques and is still in its early days. However, the recent revamp of the Bank of England’s financial stability report that I mentioned earlier was designed to give a larger role to this type of analysis. A final issue that I’d like to discuss is that macro prudential analysis cannot stop with the banking system or at the borders of a particular jurisdiction. In the past it might have been reasonable to think that systemic risk was something that began and ended with the banking system.
Page 9  Chart 6: Indicators of pay growth are elevated  Sources: HMRC, ONS and Bank calculations  A tight labour market is accompanied by resilience in business confidence. In line with evidence from the Bank’s Decision Maker Panel survey, this may reflect business-to-business pricing power within supply chains still suffering from supply disruptions. After all, within a single supply chain, one firm’s sourcing problem is another firm’s resilient demand. Supporting this view, the Banks’ Agents report that a further strengthening of margins is likely, especially in firms that are not directly facing consumer demand. Page 10  Chart 7: PMIs suggest business confidence is resilient(a)  Sources: S&P Global/CIPS. (a) A reading of above 50 indicates positive change on the previous month while a reading below 50 indicates negative change. Data for April 2022 are flash estimates. Chart 8: Banks’ Agents report further strengthening in margins is likely  (a) Question: ‘To what extent have you already passed through higher costs to prices?’  The influence of monetary policy On the back of this assessment, the current momentum in UK headline inflation developments is  Page 11  substantial. But, given lags in the transmission of monetary policy to price developments, high inflation today does not, of itself, justify tighter policy today. Rather monetary policy has to be forward looking, calibrating the policy stance to be appropriate at a horizon of 18 months to two years, once the transmission lags unwind. And that is where the MPC’s May forecast gets more complicated.