3  One explanation of this is that a household’s propensity to consume is affected by how highly indebted the household is. Studies have found that a highly-indebted household reduces its consumption more in a crisis than a lowly-indebted household. See, for example, Andersen, A.L., Duus, C. and Jensen, T.L. (2014), “Household debt and consumption during the financial crisis: Evidence from Danish micro data”, Working Paper, Danmarks Nationalbank and Mian, A. Rao, K. and Sufi, A. (2013), “Household Balance Sheets, Consumption, and the Economic Slump”, Quarterly Journal of Economics 128(4), pp. 1687–1726. 2  BIS central bankers’ speeches  total level of indebtedness. 4 I would also like to point out the difficulties that many individuals experience when bad times coincide with high private debts. An additional factor is that mortgage lending forms an important part of the Swedish banks’ assets, which means that the financial system is sensitive to risks linked with indebtedness. The banks fund as much as three-quarters of their lending for housing purposes on the market for covered bonds and access to funding on this market is based on Swedish and foreign investors being highly confident in the safety of the the underlying assets. If confidence wanes, funding costs may increase and access to funding may decline. This would disrupt the functioning of the financial system and thus have a direct negative effect on financial stability.
But in this case it can be shown that the rational expectations equilibrium does exist but is not unique. Intuitively, the fact that the central bank uses for its decision-making market forecasts, which already implicitly assume certain central bank behaviour, could produce huge output and inflation volatility. Former Fed Vice-Chairman Alan Blinder wrote about this issue: “This can create a dangerous ‘dog chasing its tail’ phenomenon wherein the market reacts, or rather overreacts, to perceptions about what the central bank might do, and the central bank looks to the markets for guidance about what it should do.” Bernanke and Woodford call the situation a “sunspot equilibrium” in which the central bank responds to random variables only because it is expected to do so. The main message I would like to pass on to you tonight is that the uncertainty surrounding the evaluation of the economy’s current state cannot be solved simply by following the market expectation. As a straightforward implication I would like to stress that the central bank must rely primarily on its own evaluation of the economy’s current state. The central bank must both develop its own structural model of the economy and gather relevant information from a variety of sources. As a consequence, surprising the market is nothing the central bank should be blamed for, and the market should be prepared to face such surprises from time to time. 2  BIS Review 10/2005