Summary of Quarterly Bulletin
February 1999

Research work published by the Bank is intended to contribute to debate, and is not necessarily a statement of Bank policy.

The impact of inflation news on financial markets
(66k)
(by Michael Joyce of the Bank's Structural Economic Analysis Division and Vicky Read of the Bank's Foreign Exchange Division).
This article examines the same-day reaction of a variety of UK asset prices to monthly RPI inflation announcements over a sample period from the early 1980s until April 1997, the month before the Bank of England was given operational independence for setting interest rates. These announcements are decomposed into their expected and unexpected, or 'news', components using survey data on financial analysts' inflation expectations. It is found that markets are efficient, in the sense that asset prices do not respond to the expected component of RPI announcements. Generally, only government bond prices appear sensitive to inflation news-particularly after late 1992, when the United Kingdom adopted an explicit inflation target. The responsiveness of implied medium and long-term forward inflation rates after 1992 is consistent with the 'expected inflation hypothesis', a finding that suggests that the pre-independence inflation-targeting framework was not seen as fully credible by the financial markets. But the declining responsiveness of bond yields and implied forward inflation rates to inflation news over the period of operation of the framework suggests that its credibility improved over time.

Monetary policy rules and inflation forecasts
(50k)
(by Nicoletta Batini of the Bank's Monetary Assessment and Strategy Division and Andrew Haldane of the Bank's International Finance Division).
Hypothetical interest rate rules for monetary policy have attracted considerable recent interest. But most such rules have tended to be based on current values of macroeconomic variables, such as output and inflation. So these hypothetical rules contrast somewhat with monetary policy behaviour in the real world, which tends to have a more forward-looking, forecast-based dimension. This article compares the use of simple backward-looking interest rate rules for monetary policy with policy rules that respond to forecasts of future inflation, in line with monetary policy behaviour in the real world. It appears that these forecast-based rules can better control both current and future inflation, by accounting for the lags in the monetary transmission mechanism, and can ensure a suitable degree of output-smoothing. In addition, they ensure that policy is responsive to most available information. Their superior performance provides support for the practice of basing monetary policy on forecasts of inflation and output, as is currently the case in the United Kingdom.

The yen/dollar exchange rate in 1998: views from options markets (182k)
(by Neil Cooper and James Talbot of the Bank's Monetary Instruments and Markets Division).
1998 was a period of unprecedented volatility for the yen/dollar exchange rate. To help to assess market participants' views on exchange rate developments, the Bank of England uses a range of techniques that employ information from the over-the-counter (OTC) currency options markets. This article describes these techniques and shows how they can be used to assist our understanding of market perceptions of the yen/dollar exchange rate over this period. Standard quotes from market-makers allow inferences about the degree of uncertainty attached to the future path of an exchange rate. In addition, the articles notes probability density functions that enable the description of a more complete distribution of agents' views. These PDFs show that agents were not anticipating a large rise in the yen in October 1998; in fact, many were buying options to hedge against a further depreciation. Information from option prices can also tell us something about market views on the efficacy of central bank intervention in the foreign exchange market. Both interventions in the yen/dollar market resulted in a short-run appreciation of the yen. But options traders did not believe that the unilateral intervention by the Bank of Japan in April, or the co-ordinated intervention in June, would change the balance of probabilities over the short term of a further sharp depreciation in the yen versus a sharp appreciation. By the end of 1998, however, traders were attaching a higher probability to a large yen appreciation than to a large yen depreciation.

Risk, cost and liquidity in alternative payment systems (66k)
(by Maxwell Fry director of the Bank's Centre for Central Banking Studies).
For its academic workshops and projects, the Bank of England's Centre for Central Banking Studies (CCBS) invites central bankers from as wide a range of countries as possible to analyse and compare their experiences of relevant issues, in a process of learning from diversity. Each workshop is followed by a three-month project, for which three to six foreign central bankers are invited to collaborate with Bank of England staff on research related to the workshop material. In this article, Maxwell Fry, director of the CCBS, summarises one aspect of the research conducted at the CCBS as part of its first academic workshop and project. This started with a one-week academic workshop on payment and settlement issues in January 1998, attended by participants from 22 central banks as well as international experts in the subject. After the workshop, six participants-three foreign central bankers and three Bank of England staff-assembled to plan a research programme for the ensuing ten weeks. The research built on the ideas presented at the academic workshop, as well as the specific interests of the team members. The results of the project research were first presented at a conference in March, which was co-hosted by the CCBS and the ESRC-supported Money, Macro and Finance Research Group. The project output also formed the basis for a report prepared for the Bank's 1998 Central Bank Governors' Symposium in June. Routledge will publish the final project output in April 1999.