Speech
The financial system has so far weathered the latest period of uncertainty. But lower growth, repeated supply shocks and changing market structures mean that resilience cannot be taken for granted.
The conflict in the Middle East has created major uncertainty about growth, inflation and interest rates. Existing vulnerabilities in sovereign debt markets, credit markets and asset valuations could crystallise together. The rapid expansion of financing connected with artificial intelligence has created new exposures, while incidents involving frontier AI have underlined the associated operational, cyber and financial risks.
However, an important part of the story so far is economic resilience in the sense that recent supply shocks have hit the world economy at the same time as the potential growth dividends from AI have become clearer.
Moreover, the story of the financial system so far has been one of resilience. Banking systems generally remain well capitalised and we are not seeing funding stress. Despite a succession of economic shocks and heightened volatility, most financial markets have continued to function without a major breakdown in liquidity or trading conditions.
Financial markets have so far withstood significant increases in sovereign bond yields, and most market adjustments have remained orderly. This resilience owes much to the reforms introduced after the global financial crisis. Those reforms are sometimes criticised as burdensome. Today, their value is clear.
But we cannot be relaxed. Experience teaches us that specific problems can emerge even when the wider system appears stable. The lesson of the global financial crisis is that such problems are much easier to manage when the wider system is resilient and the authorities are committed to keeping it that way.
The deeper economic challenge
Behind the immediate risks lie two longer-term developments.
The first is weaker potential growth, driven in many economies by slowing productivity, which determines how rapidly national income and living standards can rise.
The second is the frequency of large negative supply shocks. Covid, Russia’s invasion of Ukraine and the conflict in the Middle East have each disrupted the supply capacity of economies. Covid was also both a supply and demand shock, with the balance changing over time. But all these episodes were exceptionally large, and they followed one another with unusual speed.
Are repeated shocks the new normal? Central bankers should be wary of becoming political soothsayers. But a more multipolar world, in which economic policy is increasingly an arena for geopolitical competition, may produce more frequent disruptions. We should therefore prepare for a world in which larger shocks are not rare exceptions.
This creates a particular difficulty for monetary policy. A negative supply shock pushes inflation and output in opposite directions, producing weaker output but higher inflation.
The textbook response is to look through a one-off increase in the price level. Interest rates cannot produce more oil or gas, and monetary policy affects the economy with long lags. But looking through a shock is possible only if inflation expectations remain well anchored.
If households and businesses begin to incorporate higher inflation into wage demands and pricing decisions, a temporary shock can become persistent. These second-round effects are slower to emerge. Central banks must make forward-looking judgements and update them as the evidence changes.
The difficulty becomes greater when shocks arrive in quick succession. A recent history of higher inflation can cause people to expect further inflation. The sequencing of Covid and the invasion of Ukraine have made this risk particularly acute.
The interaction with financial stability
Supply shocks can also create tension between monetary and financial stability. Interest rates may need to rise even as economic activity weakens. Debt-servicing costs increase just as household incomes and corporate earnings come under pressure. Asset prices can fall, reducing the value of collateral and restricting the supply of credit.
This is why resilience before a shock is so important. Strong banks and sound household and corporate balance sheets give policymakers room to respond without turning an economic adjustment into a financial crisis.
Fiscal policy faces a related challenge. Lower growth and repeated supply shocks weaken the public finances while increasing pressure on governments to provide support. Higher borrowing costs and weaker growth raise debt-to-GDP ratios. If markets begin to doubt the fiscal trajectory, bond yields can rise further, tightening monetary and financial conditions.
Governments can ordinarily use their balance sheets to cushion a severe downturn and rebuild fiscal space when conditions improve. That is the principle of countercyclical policy. But when shocks become more frequent, underlying growth is weaker, and the succession of shocks leads to a higher level of government debt, this becomes much harder to sustain.
A changing market structure
Global government bond markets have also changed profoundly. They were once dominated by long-term investors, often described as “real money” and “price insensitive”. Today, leveraged investors play a much larger role, while traditional demand for long-duration debt has declined, partly because of changes in pension provision and ageing populations.
This new structure has so far increased the capacity of markets to absorb the additional supply of government debt. But greater absorption has come with greater fragility. Leveraged positions can be unwound rapidly. Losses can trigger margin calls, model-driven repricing and stop-outs, producing further forced selling that can amplify market moves. The buyers are typically more price sensitive.
The same funds may hold large leveraged positions across several countries and asset classes. Deleveraging that begins in one market can therefore spread quickly to others.
The policy response must have several parts.
First, we must pursue sustainable growth. There is no single solution, but major technological advances have historically lifted productivity. Artificial intelligence and robotics can drive scientific discovery, improve efficiency and raise prosperity. Financing that investment is essential. But greater financial exposure to AI also creates risk. If earnings expectations or confidence in the pace of AI adoption were sharply revised, the consequences could spread through equity, credit and sovereign markets. AI safety and financial stability are therefore becoming increasingly connected. Safely deployed, we should see AI as a growth opportunity.
Second, monetary and fiscal frameworks must remain credible. For monetary policy, that means an unwavering commitment to returning inflation to target. I remain sceptical of unconditional promises about future interest rates. The world is too uncertain. But central banks should explain clearly how policy would respond under different economic conditions.
Fiscal policy must likewise be directed towards stability and be seen by markets as credible. Clear frameworks, including fiscal rules, can help contain risk premia when shocks occur.
Third, we must strengthen the resilience of core markets. Greater central clearing, appropriate minimum haircuts and stronger risk management all merit consideration.
There is no quick fix. But the direction is clear: raise sustainable growth, maintain credible policy frameworks, and ensure that financial markets can absorb shocks without amplifying them.
The system has been resilient. Our task is to make sure it remains so.
I would like to thank Nat Benjamin, Sarah Breeden, Karen Jude, Andrea Rosen, Vicky Saporta and James Talbot for their assistance in preparing these remarks.
