Summary of Quarterly Bulletin
November 1999

This article continues the annual series in the Quarterly Bulletin analysing the debt position of the UK public sector. It looks at market and statistical developments in the financial year to end March 1999, and examines some of the domestic and European issues that have influenced these measures. It also analyses the composition and distribution of the national debt.

• Public sector net debt fell by £3.7 billion to £349 billion, at nominal value, during the financial year to end March 1999. This was the first annual reduction since 1989/90 At end March 1999 public sector net debt stood at 40.6% of GDP, the lowest end-March figure since 1994, and 2 percentage points lower than at end March 1998.
• General government gross debt—the 'Maastricht' measure—also fell during the year, to £399 billion at end March. At 47.4% of GDP, this is comfortably below the 60% reference value in the Maastricht Treaty. The general government had a financial surplus of 0.9% of GDP in 1998/99, well within the Maastricht reference value, which allows a deficit of up to 3% of GDP.
• All data presented in this article reflect the transition to the latest international statistical standards, the European System of Accounts (ESA95). This is consistent with the UK National Accounts, published by the Office for National Statistics. However, as before, government debt figures are still presented on a nominal, rather than a market, valuation. The box on pages 356­57 gives details of the changes and shows the impact on the measurement of the public sector debt position.

This article summarises the development of the international investment position of the United Kingdom between 1988 and the first half of 1999. It continues an annual series begun in 1985.

The article describes how financial flows and changing asset values affect the United Kingdom's external balance sheet. It relates investment income flows and capital gains to stocks of assets and liabilities, and compares the United Kingdom's international investment position with those of other major economies. A box gives details of the UK participation in the IMF-sponsored coordinated portfolio investment survey.

The Bank of England has been making active preparations to promote orderly market conditions over the Y2K period. The successful testing of the key sterling market systems—CGO, CMO, CREST and RTGS—reported in the Bank's Blue Book series gives assurance to market participants that the infrastructure will operate normally. In parallel, the Bank has taken a number of steps to ensure that sterling market participants who have made proper preparations for Y2K can obtain adequate liquidity over the period to enable them to maintain normal business activity.

This statement summarises the arrangements that will operate over the period.

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

News and the sterling markets (83k)
(by Martin Brooke, Graeme Danton and Richhild Moessner of the Bank's Gilt-edged and Money Markets Division).
The Quarterly Bulletin reports developments in financial markets in detail each quarter in the regular 'Markets and operations' article. Day by day, items of news about the economy-in the form of data releases and news about policy-are the most significant market-moving events. This article looks over a longer time period than is usually possible in the 'Markets and operations' article to answer the following two questions:

• Which news items tend to move the sterling interest rate markets most?
• How do different parts of the sterling yield curve respond to news?

The prices of financial assets adjust continually in response to news. This news can either be 'regular' (ie announcements that are released at pre-determined times known to market participants) or 'irregular' (ie events which are largely, or wholly, unexpected). This article examines how different parts of the sterling yield curve react to different types of regular news. We consider daily interest rate changes for three different assets: the nearest-maturity three-month interest rate futures contract traded on the London International Financial Futures and Options Exchange (LIFFE) (a contract based on three-month sterling Libor), the same LIFFE futures contract for a three-month interbank rate 2½ years ahead, and the yield on the benchmark ten-year gilt.

According to the expectations theory of the term structure, forward interest rates are determined by expectations of the future path of short-term spot interest rates. In other words, longer-maturity interest rates embody expectations of future short rates at all dates up to the maturity of the loan. To the extent that this theory holds, the front (ie nearest-maturity) short sterling futures contract indicates the market's expectation for the level of three-month interest rates at the maturity of the contract. Similarly, the longer-dated futures contract used in our analysis provides information about the market's expectation for the level of three-month interest rates in 2½ years' time. And the yield on the ten-year benchmark gilt should reflect average interest rate expectations over the life of the gilt (ie ten years). Changes in the prices of these three assets indicate how the term structure of sterling interest rates responds to news announcements.

The article concludes that the very short end of the sterling yield curve—as measured by the nearest short sterling contract—tends to change more on data and policy news days than on days when there is no significant news. That is also true, though to a lesser extent, for the short sterling contract two to three years ahead. Movements at the longer end of the yield curve—measured here by the change in the ten-year gilt yield—tend to be less closely tied to domestic news. Among individual domestic data releases, average earnings, RPIX and retail sales are the most significant market-moving events. Two key US data releases, consumer prices and non-farm payrolls, significantly affected the longer end of the UK yield curve.

New estimates of the UK real and nominal yield curves (83k)
(by Nicola Anderson and John Sleath of the Bank's Monetary Instruments and Markets Division).
This article presents some new improved estimates of the UK yield curve, both nominal and real. It describes the rationale for changing the estimation techniques that we have previously used, in the light of our own experience and developments in the academic literature. The article also illustrates the use of data from the general collateral repo market to derive estimates of the nominal yield curve at short maturities.

Nominal yield curves have been estimated in the Bank for more than 30 years. For the past five years, in common with many other central banks, we have used the estimation method proposed by Svensson (1994, 1995). This is a parametric method, with the entire curve described by a single set of parameters representing the long-run level of interest rates, the slope of the curve and humps in the curve. Previously we used an in-house non-parametric method described by Mastronikola (1991). And before that we used another parametric approach, with the parameters reflecting, among other things, segmentation in the market and the planning horizons of different investors.

Estimation of the real yield curve is a more recent innovation, made possible by the introduction of
index-linked bonds in the United Kingdom in 1981. As these bonds are indexed only imperfectly to the price level, we have to use information from the nominal yield curve to extract the real risk-free rates of interest embodied in their prices. Until now we have been using an iterative technique developed by Deacon and Derry (1994), in which the real yield curve is described by a restricted version of Svensson's model.

As discussed by Breedon (1995), the Svensson method was preferred both to the earlier in-house method and the range of alternative options available at the time, on the basis of three key criteria. Specifically:

• the technique should aim to fit implied forward rates (rather than, for example, yields), since the final objective is to derive implied forward rates;
• it should give relatively smooth forward curves, rather than trying to fit every data point, since the aim is to supply a market expectation for monetary policy purposes, rather than a precise pricing of all bonds in the market; and
• it should allow as many economic restrictions as possible to be imposed.

For maturities of less than two years, estimates of both the real and nominal yield curves have not been thought to be reliable, and as a result have not been used by the Bank's Monetary Policy Committee, nor published in the Inflation Report or Quarterly Bulletin. This is partly because there are few gilts at the short end of the yield curve (ie with terms to maturity of two years or less), where expectations may be relatively precise and where the curve may be expected to have quite a lot of curvature. More recently, experience has led us to question whether the Svensson estimates, even at the longer maturities, are the best guide to monetary conditions in the United Kingdom.

The opportunity to shed new light on the performance of these models has arisen, partly through the relatively recent arrival of additional information from the gilt market (in the form of strips prices), and partly through the development of new techniques for estimating the yield curve. In the latter case, we find that a new model developed by Waggoner (1997) offers a number of improvements on the parametric methods currently used to estimate both the real and nominal yield curves. In addition, improvements in extracting the real yield curve from index-linked bond prices can be found using the non-iterative technique developed by Evans (1998).

Government debt structure and monetary conditions (33k)
(by Alec Chrystal of the Bank's Monetary Assessment and Strategy Division, Andrew Haldane of the Bank's International Finance Division, and James Proudman of the Bank's Monetary Instruments and Markets Division).
In June 1998 the Bank of England organised a conference on 'Government debt structure and monetary conditions'. The aim of the conference was to discuss the interactions between the size and structure of government debt and the concerns of monetary policy. The proceedings of the conference will be published shortly. This article summarises the issues discussed.

The article identifies three main channels through which government debt structure might influence monetary conditions. These are the potential effects of:

• the quantity of debt;
• the composition of debt (eg short versus long-maturity, index-linked versus conventional); and
• the ownership of debt (eg by banks or non-banks).

Taking each of these in turn, the following conclusions about the effects of government debt structure on monetary conditions are drawn:

• Effects of the quantity of debt. The consensus at the conference was that the insights of Michael Woodford were interesting but controversial and, as pointed out by Ben Friedman, were not of great current relevance to the UK conjuncture. Rather, as Charles Goodhart argued, new financial instruments, new issuing techniques and new capital market structures since the 1980s have all helped to reduce concerns about how the quantity of debt impinges on monetary control, to the point where the two issues could now be seen as almost distinct.
• Effects of the composition of the debt. Changes in the composition of debt might affect expected asset returns and the incentives facing the central bank. But the consensus at the conference appeared to be that the size of these effects was small, at least in response to marginal shifts in government portfolios. There was nevertheless a need for monetary policy makers to monitor changes in the composition in the debt portfolio carefully, to be alert to possible effects on the monetary aggregates.
• Effects from the ownership of debt. Most of the work on this topic has been done on the United States, where there were suggestions (for instance in the work of Kuttner and Lown) that government debt taken up by banks was a substitute for loans to the private sector. For the United Kingdom, the available evidence was consistent with the view that debt sales to banks had only a small impact on either money supply growth or bank lending. But little detailed empirical work has been done to support this result. So that view can, at most, be tentative.

Overall, the economic research discussed at the conference suggested that changes in debt management policy at the margin were unlikely to have first-order effects upon monetary conditions in normal circumstances. But two important caveats are needed. First, many aspects of the transmission mechanism and optimal debt management are not well understood, and policy should aim to be robust to a variety of different assumptions and models. Second, there are few, if any, examples of extreme changes by governments in debt management policy. So it is less clear that large changes in the quantity or composition of the debt will not have implications for monetary conditions. For these reasons, the effects of changes in debt management policy on monetary aggregates need to be monitored and interpreted with care.