2  1  See Tucker, PMWT, 2008 “Making monetary policy by Committee” Bank of England Quarterly Bulletin 2008 Q3 (forthcoming) for some thoughts on the relatively collective nature of the MPC’s forecasts given its one person, one vote decisions on Bank Rate. 2  I have to say that the textbook stress on the mean (or expected value) might be somewhat overdone in some circumstances, in particular where the mean is materially influenced by certain types of low probability/high impact risks. I hope the following will illustrate that. Imagine, not in the current context, that there is a risk of a dollar collapse against the euro, the currency of the UK’s largest trading partner, but without a similar risk of sterling collapsing. Say the probability is judged to be low, but the impact large; so that, in the probability-weighted way, it is enough to shift the mean outlook for future inflation. If (if) the risk crystallised,  BIS Review 112/2008  1  Now, putting this together, the following inference can be drawn; and I hope that I shall be excused if I plod through this in slow motion. Focusing on a roughly two-year horizon, if inflation was most likely to be below target in the context of the August modal forecast for output, then it would be even further below target if the MPC’s view in August of the downside risks to growth were to materialise (ie consistent with the mean path for output but no further adverse shock to costs).
But it’s less obvious, at least to me, what macroeconomic developments I should expect if risk premia rose due to an “exogenous” rise, say due to reduced market making, in the volatility of asset prices. We also need to be able to make sense of shifts in relative risk premia on different asset classes. We need models that can say something useful about the compression, and then widening, in credit and liquidity risk premia that in some ways define the current financial turmoil. We need to know whether or not those shifts reflect changes in fundamentals, or unwarranted “exuberance” or “fear” in the markets; and whether or not they have implications for demand and supply conditions in the real economy. Second, very little has been said about how, or whether, the supply of money (or monetary policy) may affect risk premia. Years ago Brunner and Meltzer set out a view 20 of how shocks to the supply of base money were transmitted to the economy through effects on asset prices over and above the impact on the risk-free discount rate, but through liquidity (and maybe other risk) premia. More recently, some policymakers, 21 have conjectured that swings in the supply of broad money (via bank lending) can be associated with shifts in risk premia too. The thought is that in a world in which different assets are not perfect substitutes for each other, whether money is over or under-supplied can affect the relative value of other financial assets.