Faced with that, a central bank’s instrument – used, where necessary, in collaboration with its regulatory and finance ministry partners – is to supply the system  6  Chaplin G, Emblow A and Michael I (2000), “Banking system liquidity: developments and issues”, Bank of England Financial Stability Review, December 2000, pp 93-112. 4  BIS Review 44/2007  with an increased quantity of its money, without necessarily changing its price. Given the need to take collateral to protect against risk, and to charge a premium to create the right incentives, establishing a routine framework for such operations without creating moral hazard remains “work in progress” for the international central banking community. 7 So it would seem that there is a good deal to welcome in the greater dispersion of risk made possible by modern instruments, markets and institutions. But there are most certainly qualifications to such an apparently alluring conclusion. b)  The banking system’s residual risk, stress testing and transparency  The banking system retains risk in a number of ways, both pre- and post-risk transfer, and its aggregate balance sheet has in fact expanded considerably. 8 Pre-risk transfer, banks and dealers hold, or finance, warehouses of portfolios of loans to households and corporates on their way to securitisation, 9 meaning that the banking system can still find itself “holding the parcel” when the music stops. Post-risk transfer, some risk is contingently retained by virtue of banks and dealers financing the acquisition of risk by hedge funds and others.
Given that inflation is anticipated to be below target for a large part of the coming two-year period, I think one can argue that there has been scope to lower the repo rate somewhat more than we have done recently. But I have, like my colleagues, decided against this. There are several reasons for that – interest rates do not always have to be changed when inflation prospects differ from the target. The reasons are that growth is currently firm. We believe that the problems in the labour market are chiefly due to structural factors; it is therefore likely that they would only be marginally affected by lower interest rates. Moreover, the demand for labour is expected to begin to rise during 2005-2006, Swedish monetary policy is already loose, real interest rates are low, household borrowing is increasing quickly and house prices are rising - and have been for a long time. Even lower rates could further fuel the willingness to borrow, entailing risks in the long term in the shape of a growing property bubble. In addition, if monetary policy is to try to fully offset the low import prices by driving up domestic prices, for example in the service sector, this could lead to a domestic inflation rate that would be difficult to stop if economic activity were to continue to develop strongly for a longer period and resource utilisation thereby to rise.