A recent paper by Michael Woodford 13 concluded that information from money and credit quantities could not add anything to spreads; and, what is more, that they were not as useful as spreads because the quantity effects of a tightening become apparent only with lags. The set up in Woodford’s paper does not, however, involve quantity rationing. When such rationing occurs, data on the quantity of lending and money may be more useful, even with a lag, than the shadow prices that cannot be observed! Of course, I absolutely do not want a reversion to oversimplified Monetary Conditions Indices, which set a trap for policymakers by ignoring the nature of the shocks that shift credit supply and other financial variables. But we do need to have a better quantitive understanding of how the equilibrium real rate (r star) shifts with shocks to the financial parts of the economy. For UK policymakers, overall, the sharp slowing in corporate and household credit and money growth signals that monetary conditions are quite tight. Tighter bank lending conditions will make it harder for households to maintain their spending during this testing period – when the rise in energy and food prices has squeezed disposable incomes; and when the savings rate was already low. Similarly, with less easy access to credit, it will be harder for firms to bridge to the expected recovery without cutting costs. On the whole, the corporate sector probably entered this episode with stronger balance sheets, leveraged buyouts aside, than the household sector.
In the modern literature, these risk premia are taken to be determined by how useful a financial asset is in helping households to smooth the path of their consumption. Assets that deliver low returns during bad times don’t contribute much to helping households sustain consumption, and so carry a higher risk premium. So risk premia might vary with the volatility of the asset return; the volatility of consumption; and with the correlation between asset returns and consumption. 16  See Dooley, M.P, Folkerts-Landau, D and Garber, P (2003), “An essay on the revised Bretton Woods System”, NBER Working Paper 9971. “System” is not quite the right word, because it is not the product of collective international thought and planning. 17  See Tucker, PMWT (2006) “Uncertainty, the implementation of monetary policy and the management of risk”, Bank of England Quarterly Bulletin 2006 Q2 pp 202-211. BIS Review 112/2008  9  Like other economic variables, such premia may change as their underlying determinants change, and given the nature of the “shocks” affecting the macroeconomy. All that is familiar, fairly orthodox stuff these days. Indeed, an extraordinary amount of work at the macro/financial frontier has been going on over recent years. But as John Cochrane has commented, “work has barely begun”. 18 From a policymakers’ perspective, that does seem to be the case.