But consumer spending appears to be weak, nominal wage growth remains relatively muted and once we strip out the impact of rising commodity prices, output price inflation has been steady. To paraphrase Sherlock Holmes, if expectations have become detached, it is curious that those dogs haven’t barked. So in my view the news on that front has been encouraging. The impact of the credit crunch And of course, we have been balancing that upside risk to inflation from the commodity price shock against a downside risk that the credit crisis would drive down activity too far and push inflation below target in the medium term. And the news on that front remains worrying. The headlines are about the drama on Wall Street but the failure or rescue of even big and well known financial firms matters mainly because of their knock on impact on the wider economy. The last year has brought home once again why central banks have to be concerned with financial stability as well as monetary stability and inflation. For the biggest risk to the financial sector is also the biggest downside risk to the economy: namely that damage to bank balance sheets would lead to tighter credit conditions, lower asset prices, lower consumption and investment and to a severe feedback loop into more losses for banks and so on down a spiral. That feedback is already working to some degree not just in the US but in the UK too.
We will continue to work for the return of calmer financial markets. But we should not rely on that to reverse quickly the broader macroeconomic slowdown that is underway. Indeed there are still risks to the downside and I thought it might be useful to spell out how they feed through the economy and therefore make plain what indicators I will be focusing on in the next few months. BIS Review 114/2008  3  Any contraction in lending to the real economy can amplify the slowdown in demand (Chart 6). Increases in retail lending rates for those who can still get access to credit discourage spending. Increases in credit rationing can have a more dramatic impact. If those households and companies are unable to tap other sources of finance, then their spending will have to fall back in line with income. Spending on high cost durable goods – such as purchases of cars and white goods by households and machines by companies – are likely to be particularly affected. And the contraction in mortgage lending pushes down house prices, further eroding the value of the collateral against which banks’ loans are secured. Tighter credit conditions raise income gearing, forcing households and companies to devote a larger share of their income to servicing debt. And as the impact of those tighter credit conditions bite on the economy, income is likely to be squeezed and that at the same time as real incomes are being affected by higher food and energy prices.