It could accelerate if and when Brexit uncertainty is resolved in which case aggregate credit could begin to grow quickly and the FPC would need to consider how to respond. One can explain the increase in mortgage lender appetite by fierce competition in the mortgage market, generated in part by changes in the structure of UK banks following the implementation of ring fencing. But should we also infer any signal about sentiment and expectations? One could ask a similar question about the very aggressive growth in leveraged lending to corporates in the US, which in 2017 spread to the UK.29 The stock of UK leveraged loans is estimated to have grown by about a third in the year to 2018 thanks to gross loan issuance in that period which was nearly 70% larger than the preceding 12 months. This has been accompanied by a very marked reduction in underwriting standards for these loans, a large proportion of which have been securitised and sold to international investors. Overall, credit to UK corporates is growing pretty slowly and leveraged loans are a relatively small proportion of total lending to corporates; so what does the explosion of activity in the UK leveraged loan market tell us? A better understanding of what drives the formation of expectations in this area might also help us to decide how to react to these ‘pockets’ of increasing risk appetites. Should we treat them as idiosyncratic and unrelated and respond to them as such?
Households, businesses, and investors will often extrapolate the recent past to form their expectations of the future – if house prices have been growing, they consider further growth more likely.13 Robert Shiller’s 2000 book, Irrational Exuberance, demonstrated how there had been a clear, negative correlation between price to earnings ratios for US stocks in the 20th century and realised returns in the following ten years. At the time of publication, US stock markets had record high price to earnings ratios of more than 40 times – soon to be followed by the dot-com crash. Asset price bubbles and investment manias are often attributed to such ‘extrapolative’ expectations.14 In the first stage investors extrapolate from past performance which pushes up the price of the asset. A bubble dynamic then develops in which investors are drawn to buy the asset not for the extrapolated underlying performance but for the very short term capital appreciation. As the price growth represents demand for the asset based on the past behaviour of its price – and not information about what it will yield in the future – it will not be sustainable. These are of course very different views of how expectations are formed. Where prices in a rational expectations model are fully forward-looking (future performance determines today’s price), prices in an extrapolative world are fully backward-looking (past performance determines today’s price).