Summary of Quarterly Bulletin
Winter 2001

Research work published by the Bank is intended to contribute to debate, and does not necessarily reflect the views of the Bank or of MPC members.

The formulation of monetary policy at the Bank of England (86k)
(By Charles Bean, Executive Director for Monetary Analysis and Statistics and Chief Economist, and Nigel Jenkinson, Deputy Director for Monetary Analysis and Statistics).
This article explains how the Committee currently discharges its main responsibilities, and describes the key internal processes underlying the monthly MPC meetings and the quarterly forecast round leading up to the publication of the Inflation Report. These processes have evolved over time, and the Committee and the Court of Directors of the Bank review them regularly to ensure that they work efficiently and that they conform to best international standards. The processes will no doubt continue to evolve in the future as the Bank strives to find better ways of operating.

Credit channel effects in the monetary transmission mechanism (97k)
(By Simon Hall of the Bank's International Finance Division).
Economic models often assume for simplicity that the impact on the wider economy of changes in financial conditions can be summarised by a relatively limited set of financial variables, such as short-term risk-free interest rates and long-term government bond rates. However, financial developments can, at times, have important effects on the economy, which these variables would not necessarily indicate. For example, following the suspension of debt payments by Russia in the summer of 1998 and the emergence shortly afterwards of problems at the hedge fund Long Term Capital Management (LTCM), interest rates on corporate debt rose relative to rates on government debt, and a number of central banks reduced official interest rates to mitigate possible effects on spending in the wider economy. In practice, policy-makers take account of a wide range of information on conditions in financial markets to monitor, and potentially respond to, these sorts of developments.

This article reviews potential theoretical explanations for two features of finance provision—the apparent preference by many borrowers to finance spending using own funds, and for many of those who do borrow, to rely on bank rather than capital market finance. These so-called 'credit channel' models help to explain why borrowers' financial positions might affect their spending, and why shocks to banks can have a marked impact on borrowers that are particularly dependent on bank finance. As such, these models illustrate some important interactions between the monetary and financial stability objectives of central banks and highlight the need for policy-makers to monitor a wide range of financial indicators.

In practice, banking system distress and significant disruptions to bank loan supply are relatively rare in developed banking sectors, as in the United Kingdom. As such, bank lending credit channel effects may be relatively infrequent. Balance sheet credit channel effects probably play a more continuous role in the economy, but they too will likely vary in strength over time, reflecting structural changes in the financial system and cyclical fluctuations in borrower financial health. This article focuses on a representative model of balance sheet effects. Two other articles in this Bulletin use the framework of this model to show how credit channel effects may affect spending in the UK corporate and household sectors.

Financial effects on corporate investment in UK business cycles (158k)
(By Simon Hall of the Bank's International Finance Division).
The depth and persistence of the UK recession of the early 1990s surprised many economic forecasters, particularly the prolonged weakness of corporate investment growth. Views on the causes of sluggish investment in this period vary. However a number of analyses have suggested a potential role for financial factors, noting the coincidence of weaker corporate investment with a marked financial retrenchment by the sector.

This article focuses on the potential role of corporate financial health in investment behaviour in the early 1990s. It does so by examining whether the theoretical predictions of a macroeconomic model explicitly designed to allow for interactions between real and financial factors are consistent with features of observed behaviour. This 'financial accelerator model', which includes potential for financial effects, is used as a tool for analysing possible shifts over time in the strength of interactions between corporate financial conditions and investment. Model simulations suggest that financial effects may have been more important in the early 1990s recession than in the 1980s recession.

Clearly these simple experiments cannot hope to explain the complexities of investment behaviour in recent recessions: the article does not claim that financial accelerator effects were the single, or even the most important, determinant of corporate investment behaviour in the early 1990s recession. But the model-based results do illustrate that relationships between financial conditions and real behaviour can vary substantially over time. In this way, the exercise highlights the importance of monitoring interactions between corporate financial fragility, finance supply and investment spending.

Why house prices matter (112k)
(By Kosuke Aoki, James Proudman and Gertjan Vlieghe of the Bank's Monetary Assessment and Strategy Division).
House prices in the United Kingdom have received a great deal of attention from policy-makers and economic commentators. It is often assumed that if house prices are growing rapidly, consumption growth will be strong too. But the economic links between house prices and economic activity are complex. Houses are different from other assets for two reasons. First, people usually live in their houses and value directly the services provided by their home. So the benefit of an increase in house prices is directly offset by an increase in the opportunity cost of housing services. Second, UK houses are not widely traded internationally. So UK homeowners in aggregate cannot realise their capital gains on houses to increase consumption. All UK homeowners cannot simultaneously move out of homeownership. The gain to a last-time seller is therefore also a loss to a first-time buyer, who will usually be a UK consumer too. This contrasts with capital gains on financial assets, which can be realised in aggregate in the United Kingdom, if overseas agents are willing to buy the assets. So there is no traditional 'wealth effect' on consumption from housing in the way that we think of a wealth effect arising from a change in the value of households' financial assets.

But there are other reasons why house prices and consumption may move together. First, if consumers are optimistic about economic prospects, they are likely to increase their consumption of housing and non-housing goods alike. Second, if house price increases are accompanied by an increase in housing transactions, as they often are, these transactions may have a direct effect on consumption as people buy furniture, carpets and major appliances for their new home. Third, house prices may have a direct impact on consumption via credit market effects. Houses represent collateral for homeowners, and borrowing on a secured basis against housing collateral is generally cheaper than borrowing on an unsecured basis (via a personal loan or credit card). So an increase in house prices makes more collateral available to homeowners, which in turn may encourage them to borrow more, in the form of mortgage equity withdrawal (MEW), to finance desired levels of consumption and housing investment. The increase in house prices may be caused by a variety of shocks, including an unanticipated reduction in interest rates, which will lower the rate at which future housing services are discounted.

This article describes in detail how this credit market channel may form part of the monetary transmission mechanism. It also considers the implications for monetary policy of recent structural changes in the United Kingdom's retail financial markets. Increased competition has widened the availability of retail credit and reduced its price. In the mortgage market, there is now a wider range of products, and it has become easier for consumers to withdraw housing equity to finance consumption. Other consumer credit products are also more widely available, so that credit constraints in the United Kingdom may be lower now regardless of the level of house prices.