Summary of Quarterly Bulletin
May 1999

This report has been prepared by Bank of England staff under the guidance of the Monetary Policy Committee in response to suggestions by the Treasury Committee of the House of Commons and the House of Lords Select Committee on the Monetary Policy Committee of the Bank of England.

The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the 'transmission mechanism' of monetary policy.

The purpose of the paper is to describe the MPC's view of the transmission mechanism. The paper is in two parts.

Part I describes the links from official interest rate decisions to economic activity and inflation. It discusses aspects of these links such as the distinction between real and nominal interest rates, the role of expectations, and the interlinking of many of the effects mentioned. There is also a discussion of the role of monetary aggregates in the transmission mechanism.

Part II provides some broad quantification of the effects of official interest rate changes under particular assumptions. There is inevitably great uncertainty about both the timing and size of these effects. As to timing, in the Bank's macroeconometric model (used to generate the simulations shown at the end of the paper), official interest rate decisions have their fullest effect on output with a lag of around one year, and their fullest effect on inflation with a lag of around two years. As to size, depending on the circumstances, the same model suggests that temporarily raising rates relative to a base case by 1 percentage point for one year might be expected to lower output by something of the order of 0.2% to 0.35% after about a year, and to reduce inflation by around 0.2 percentage points to 0.4 percentage points a year or so after that, all relative to the base case.

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

Monetary policy and the yield curve (33k)
(by Andrew Haldane of the Bank's International Finance Division and Vicky Read of the Bank's Foreign Exchange Division).
This article examines and interprets movements in the yield curve at the time of changes in monetary policy. A perfectly transparent, fully credible monetary policy will insulate the yield curve from jumps at the time of monetary policy changes. Indeed, stability of the yield curve around the time of monetary policy changes provides one measure of the degree of transparency and credibility of a monetary regime.

Most monetary regimes are less than perfectly transparent and credible. Typically, the yield curve does jump at the time of official rate changes. But evidence in the United Kingdom suggests that these yield-curve shifts have been dampened considerably since the introduction of inflation targeting and the transparency reforms that have accompanied it. Greater transparency has manifested itself in greater stability in the yield curve, especially at the short end. As the credibility of the inflation-targeting regime grows, longer-maturity yields might also be expected to be more stable following policy changes.

The Bank's use of survey data (66k)
(by Erik Britton of the Bank's Structural Economic Analysis Division, and Joanne Cutler and Andrew Wardlow of the Bank's Conjunctural Assessment and Projections Division).
The Bank of England's Monetary Policy Committee (MPC) is charged with the task of achieving the Government's inflation target. A central part of this task involves interpreting information about the current state of the UK economy, and assessing its medium-term prospects. Surveys form part of the broad range of information available to the MPC, along with official statistics, data from financial markets, and the information provided by the Bank's regional Agencies. In this sense, surveys complement other sources of information. But importantly, the forward-looking nature of many survey responses means that they often provide information that is additional to official and other sources of data.

This article outlines how Bank staff use state-of-trade type surveys: as a timely indicator of forthcoming official data; as an independent cross-check on official data and other information; as forward-looking information on the economy, particularly up to the short-term horizon; and to provide additional information to explain economic behaviour. It discusses a variety of approaches the Bank uses to assess survey information, and to identify news about the economy. The article outlines how simple observation can be useful, and explains how qualitative survey information is transformed into quantitative estimates and how incremental news might be extracted from surveys. The approaches described illustrate how surveys help the MPC to interpret economic conditions, and resolve puzzles and uncertainties about the economic outlook.

Surveys complement official and other information; they are not a substitute for it. Many surveys are based on smaller, and less representative, samples than the official statistics. So they may be subject to bias, or to a higher degree of measurement error than the official data. The MPC has to form a judgment based on all available information, of which survey evidence is one valuable source. The techniques described reflect the Bank's aim to use this evidence as systematically as possible to inform the MPC's policy decisions.

Monetary policy and uncertainty (50k)
(by Nicoletta Batini, Ben Martin and Chris Salmon of the Bank's Monetary Assessment and Strategy Division).
This article describes various types of uncertainty that policy-makers may face. It summarises analysis, including recent work by Bank staff, that shows how different forms of uncertainty could lead to different policy responses.

The article reviews how economic theory suggests that monetary policy-makers should take account of different types of uncertainty. This is an area where economic theory lags behind practice. Policy-makers have always had to make allowances for all the uncertainties that they perceive.

Theoretical analysis has tended to consider only very specific and tightly defined forms of uncertainty. A key result- that policy-makers should act as if certain - is applicable only when policy-makers have considerable information about the structure and state of the economy. The second section of this article shows how this certainty-equivalence result breaks down once it is assumed that policy-makers are unsure about the relationship between variables in the economy or, in some circumstances, on account of measurement error, about the current state of the economy. Such uncertainties by themselves are likely to result in smaller policy responses to economic developments. The results from the studies summarised in the third section of the article provide some evidence of this effect.

But these studies take account only of the effect of parameter uncertainty. In practice, policy-makers' uncertainty is likely to be deep-seated, not least because they are unsure about the basic structure of the 'true' economy. Neither these studies, nor other empirical work, provide a unified analysis of the effects of all forms of uncertainty upon policy. In short, a consensus view has yet to emerge from the academic literature as to how policy-makers should deal with uncertainty.

An effective exchange rate index for the euro area
(83k)
(by Roy Cromb of the Bank's Structural Economic Analysis Division).
Since 11 May, the Bank of England has published a daily effective exchange rate index for the euro area. The index is calculated using close-of-business rates in London, and is supplied to agencies such as Datastream, Reuters, Bloomberg and the Financial Times. It is compiled on the basis developed and used by the International Monetary Fund (IMF), as with the other effective exchange rate series published by the Bank.

This article describes the calculation of the index since the initial value of the euro was set on 31 December 1998, and also for the preceding period. The index is calculated by weighting together the individual exchange rates of the eleven euro-area countries against non euro area currencies; so it represents an effective index for the eleven countries as a group, rather than for the euro as a currency. The base year for the series is 1990, the same as the other effective exchange rate series published by the Bank and the IMF.

The article compares the Bank's euro-area index with recent movements of the euro against the US dollar, sterling, the Japanese yen and the Swiss franc; with the Bank for International Settlements (BIS) index provisionally used by the European Central Bank (ECB); and with the IMF's 'broad' euro-area index, which has a greater country coverage. It also notes how the introduction of the euro has affected the exchange rate indices for individual countries.

The financing of small firms in the United Kingdom
(66k)
(by Melanie Lund and Jane Wright of the Bank's Domestic Finance Division).
Economists have often argued that imperfections in the financing of small firms arise because of information asymmetries: the small business owner generally has much better information than the bank on his firm's performance. This is fundamentally different from the situation with large companies. This article examines the developments over the past decade in the financing of small businesses in the United Kingdom. It notes the sector's reduced dependence on external funds and increased use of a range of financing products. The article also assesses the current risks faced by the small firms sector and its providers of finance, suggesting that this sector is now more resilient to a downturn in the economy than in the early 1990s, thus reducing the likelihood of a recurrence of the high levels of business failures experienced in that recession.

The article looks at the economic theory on the provision of finance in the small firms sector, indicating how market failures in the financing of small firms could arise from information asymmetries, leading to problems of adverse selection and moral hazard. Empirical evidence provides little conclusive support for the existence of such imperfections, but the theory highlights banks' problems in undertaking risk assessment of these firms.

The article examines how the patterns of small firms financing have changed over the past decade, making it less likely that the high levels of business failures and bank losses experienced in the previous recession will recur. It was noted that small businesses are now more appropriately financed than in the early 1990s. They are more dependent on internal sources of finance - with many of the smallest businesses being net creditors to the banking sector - and businesses that do require external finance now use a wider range of finance products. Traditional bank finance does, however, remain the most important source of external finance for small businesses.

Market competition in the provision of finance to small firms was identified as a means of facilitating and maintaining the momentum for improvement. The providers of bank finance to small businesses operate in a concentrated industry, but the degree of competition in this market is increasing, because of technological changes and new entrants.

One area where improvement in the provision of finance is less evident is in the supply of risk capital for technology-based small firms. Problems appear to arise at the start-up stage, where supplies of 'seedcorn' and early-stage equity finance are limited. Many formal venture capital firms tend not to invest in small enough amounts for these companies, and the informal venture capital market (business angels) is still underdeveloped compared with that in the United States.

Structural changes in exchange-traded markets
(33k)
(by Claire Williamson of the Bank's Market Infrastructure Division).
This article outlines the main recent structural changes in exchange-traded markets-mergers between equity and derivatives exchanges, new international links between exchanges, and changes in exchanges' ownership structure. It analyses the factors that have prompted these developments, and reviews the implications that the changes may have for market-users, other types of infrastructure and the authorities.

The structure of exchange-traded markets continues to change. Three distinctive - and linked - trends are: mergers between equity and derivative exchanges within countries, new types of links between exchanges in different countries, and demutualisation. Links between exchanges are not new, and exchanges have been undertaking cross-listing links for a number of years. For example, the Chicago Mercantile Exchange (CME) and the Singapore International Financial Futures Exchange (SIMEX) have linked to cross-list the CME's eurodollar contract since 1984. What makes the current trends particularly significant is the nature of the economic forces driving change, particularly those arising from technological development, and the implications for market-users, other types of infrastructure and the authorities. The Bank's interest in this arises from its purpose of maintaining the stability of the financial system, and the effectiveness of UK financial services.

The current changes in market structure are comparable in scope to the changes that have happened to regional equity markets within countries. These regional markets gradually consolidated as communications improved, leaving most business being done in one national exchange in most countries. For example, the UK regional stock exchanges consolidated as long ago as 1973. This article describes three of the more recent trends in market structure and analyses the key factors driving these changes. It focuses on supply-side factors, though demand-side factors, such as changes in the demand for instruments resulting from EMU, are clearly also important.