The UK economy is entering a period of heightened and sustained volatility as the Bank of England (the “Bank”) begins a series of rapid and aggressive adjustments in monetary policy. The Bank’s loose monetary policy stance was first adopted during the Global Financial Crisis (14 years ago). In normal circumstances, the economy would be functioning independently, with inflation forecasts at or pointing towards the Bank’s 2% target and improving consumer and business sentiment promoting confidence in the UK economy’s capacity for sustainable growth.
Questions as to why the Bank maintained such a loose monetary policy stance broadly recognised to have inflamed a severe inflationary crisis are becoming louder. The UK economy has entered a cost-of-living crisis not seen in a generation and will lead to significant contraction in the standards of living for millions of people up and down the country. The effects of the cost-of-living crisis, alongside the impact of higher inflation on the ability of firms to manage costs, are beginning to show in consumer and business sentiment surveys. Notwithstanding, the Bank must act to mitigate the effects of inflationary risks for consumers and businesses, with current inflation forecasts suggesting a protracted period of above-target inflation, such as consumer inflation predicted to reach 9% in late 2022. The challenge for the Bank is how and when to act in a way that minimises risks to derailing the UK economy from the post COVID-19 pandemic recovery.
In February 2022, I wrote to the UK’s Chancellor of the Exchequer recommending an independent investigation into the Bank’s use and reliance of historical models to forecast future economic risks. It is possible the Bank has failed to adequately consider the material impact on UK economic activity caused by changes in the functioning of the economy led by the onset of the 4th Industrial Revolution, such as the widescale adoption of technology across economic sectors, the effect of the “gig economy”, or how the multi-trillion-pound technology industry is changing consumer and business behaviours.
In 2020, I issued a paper called New Markets, New Models which characterised the limitations of historical corporate credit and liquidity risk models caused by the widescale effects of the 4th Industrial Revolution. The paper articulates the need for firms to build new credit and liquidity forecasting models to “…predict how consumer behaviours and changing markets will affect exposure to credit and liquidity risk. Ultimately, it will be understanding these risks and ensuring financial flexibility to make appropriate adjustments which will impact company survival during the 4th Industrial Revolution. This requires a fresh approach to credit and liquidity planning that is more predictive and uses new models to remain profitable.”
As we enter a period of heightened economic volatility, firms must start to analyse their financial resilience against a deteriorating economic outlook and consider the compounded effect of elevated non-financial risks each with the propensity to cause material financial harm (e.g., trade tensions caused by escalating geopolitical risks).
Firms must also consider the effects of the 4th Industrial Revolution as they steer through this next economic downturn. Embedding financial resilience will require careful consideration of both financial and non-financial risks across the value-chain of important products and services, and forward-looking analysis into the effect on financial resilience if and when these risks collide.
The risk alert (below) issued to companies registered with Risk Panorama alongside the board’s of FTSE100 companies (not already registered with Risk Panorama) provides practical examples to build and test forward-looking financial resilience suitable for the external environment in which we find ourselves today.
This risk alert has been made available for general download.
