From those assumptions are derived equations of motion for the behaviour of  4  All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx  4  consumers and firms – which, rather revealingly, are often called the Euler conditions. Then, and only then, are these first-order conditions for behaviour taken to the data to be tested. These models, so derived, predictably exhibit the same damped harmonic motion as Newton’s pendulum. Let me give a couple of examples of this approach in mainstream practice in economics and finance. The most famous equation in finance is probably this one:  Figure 1: The Black-Scholes Formula  Source: Black and Scholes (1973). This is the Black-Scholes options pricing formula (Black and Scholes (1973)). Under a (relatively) small set of assumptions, it provides a (relatively) simple analytical description of how to price a financial option. It cannot rival Einstein for its simplicity and aesthetic beauty. But it nonetheless has many of the trademark characteristics of theoretical physics. That should come as no surprise because this equation was itself drawn from theoretical physics. In seeking a solution to their option-pricing problem, Fisher Black, Myron Scholes and Robert Merton drew an explicit link between their contingent-claims pricing problem and the heat transfer equation in physics (Churchill (1963)). If not quite a lift and shift from theoretical physics, the Black-Scholes formula was certainly a genetic mutation.
Does that imply that consumers would shrug off a downturn in the housing market? Not necessarily. The rise in house prices has meant that households have taken on a lot of debt, and higher interest rates will mean they have less money to spend on other things. While there are few signs of obvious financial stress at current interest rates, given the strength of the current jobs market and the current housing market, this could change, especially if several of these factors weakened at the same time and the economic climate deteriorated sharply. That’s a long way from our central forecast, but uncertainty about how consumers might react to higher interest rates has been an important reason for tightening policy gradually since last November. We have also avoided springing surprises. I think that’s important: people are more likely to believe what we say, if our behaviour is reasonably predictable. But we wouldn’t be doing our job if we didn’t constantly revise our views in the light of new information and new research. That is why every month has to be a fresh decision. And why I can honestly say that I don’t know, any more than anyone else, where rates will be in a year’s time. Compared with a year ago, interest rates have risen from 3.5% to 4.5%. But the international outlook is clearly stronger now, the domestic economy is buoyant, and inflation remains low.