This has created tensions between short-term output and inflation stabilisation in the UK that have not been evident in other major economic regions. Chart 1: Divine coincidence has continued in the euro area Great moderation  5  Inflation (%)  Financial crisis and after 4 3 8 2 -4  -3  -2  -1  0 1  1  2  3 4 Excess demand (%)  0 -1  3  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  3  But not in the United Kingdom Great moderation  6  Inflation (%)  Financial crisis and after 4  Inflationary, with trade-off  Inflationary, no trade-off  2 -6  -5  -4  -3  -2  -1  0  1  2 3 4 Excess demand (%)  0 Disinflationary, no trade-off  Disinflationary, with trade-off -2  In these circumstances it has been critical for the Bank of England to pursue flexible inflation targeting.2 Since 2013, the MPC’s remit has explicitly recognised that there are circumstances in which bringing inflation back to target too quickly could cause undesirable volatility in output and employment. It directs the MPC to “promote understanding of the trade-offs inherent in setting monetary policy” including importantly “the horizon over which the Committee judges it appropriate to return inflation to target”. The MPC used this flexibility to support activity following the referendum in the wake of the large depreciation.
As wholesale investors started to exit, this set in motion a bad dynamic – a fire sale of assets that cut into earnings and capital. This increased the incentives of investors to run and for banks to hoard liquidity against the risk that they could themselves face a run. This downward spiral of fire sales and funding runs was a key feature of the financial crisis. The inherent fragility of short-term wholesale funding was greatly aggravated by certain institutional shortcomings in these markets, particularly in the structure of the tri-party repo system and the U.S. money market mutual fund business. Through the tri-party repo market, each day the two large clearing banks were providing a large amount of intraday credit to securities firms to facilitate the daily “unwind” of the prior day’s transactions. In the run-up to the crisis, the daily “unwind” helped make tri-party repo  2  BIS central bankers’ speeches  look like a very liquid investment while still being an apparently highly durable source of funding. This masked the underlying risks and contributed to weak risk management practices. As the concerns about the U.S. housing market escalated in 2007, participants in the tri-party repo market became increasingly concerned about the liquidity and credit risks that they faced. The clearing banks became uncomfortable with their large intraday exposures to their clients – broker-dealers, thrifts and others.