However, once the economy has significantly improved, both fiscal and monetary policy will need to be much less accommodative. Getting this balance right will be one of the main policy challenges over the next several years. I am confident that the Fed’s Federal Open Market Committee (FOMC) will meet the challenge. Finally, I’d like to note that even with some early signs of economic improvement, a number of risks remain. As I have highlighted today, the housing market remains fragile and is not likely to contribute to economic recovery in its traditional way – and this is part of why I do not expect growth to exceed 4 percent in 2011. Furthermore, in many areas of the country the impaired balance sheets of borrowers, high foreclosures, and high vacancy rates imply a long time before local housing markets normalize. State and local governments remain significantly challenged by the aftershocks of the financial crisis and recession. And many state and local governments continue to have both short-run and long-run fiscal challenges. Finally, the large fiscal deficits of many governments accrued during the recession will need to be addressed. And as Figure 17 shows, financial markets are concerned that many countries will be forced to make very painful fiscal choices – in economies with already significant challenges – or risk default. Yet while risks like these remain, the economy is in a much better place than it was one or two years ago.
Depending on what had happened to sterling’s bilateral exchange rates, the UK would not be immune from spillovers, as the euro area is by far our largest trading partner. For some time, therefore, global imbalances have been a real source of risk to the UK as well as to the global economy. Should I have been voting to cut interest rates to head off those risks? I don’t think so. It would not have made sense to try to anticipate the effects of a shock that had not yet occurred and over which we had effectively no influence. A number of external ‘tail risks’ are rather like that. How does that fit with ‘precautionary’ or ‘insurance’ policy settings. Individual policymakers differ on the usefulness of this concept. I find it quite useful. But on my view of what it means, it has to be subject to some quite stringent conditions in practice. Remembering that we have a highly imperfect line of sight of what is going on in the economy, assume as a thought experiment that some indicators are flashing the possibility that there has been a material shock to demand. For example, imagine that there has been a bit of bad news but that there  15  Harrison et al, 2005, ‘The Bank of England Quarterly Model’, pages 128-132. BIS Review 46/2006  5  are signs that consumer confidence may be ebbing away by more than we would have guessed was proportionate. So maybe spending will fall materially.