Bank of England Working Papers - Abstracts 2009 (no. 360 - 378)

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The following are brief abstracts of working papers published during 2009.

You can also view the full text of working papers 23 and 24 (from 1994) and working papers since 1997 as PDF files, readable with the latest version of Adobe Acrobat (this is available free from Adobe's Website). The working papers are listed with the most recent papers first.

Working Paper No 378
Do supermarket prices change from week to week?
Colin Ellis
(502k)

This paper examines the behaviour of supermarket prices in the United Kingdom, using weekly scanner data supplied by Nielsen. A number of stylised facts about pricing behaviour are uncovered. First, prices change very frequently in supermarkets, with 40% of prices changing each week, and even controlling for 'temporary' changes, a quarter of prices change each week. Importantly, there is evidence that focusing on monthly observations, rather than weekly ones, overstates the implied stickiness of prices. Second, the probability of price changes is not constant over time - all product categories have declining hazard functions. Third, the range of price changes is very wide, with some very large price cuts and price rises; but despite this, a significant number of price changes are very small. Fourth, there appears to be little link between the frequency and magnitude of price changes - prices that change less frequently do not tend to change by more. Fifth, the strongest correlation between price and volume changes is contemporaneous, suggesting that prices and volumes move together from week to week. And sixth, rough analysis based on simplifying assumptions suggests that consumers are fairly price sensitive: volumes change by more than prices.

Working Paper No 377
International spillover effects and monetary policy activism
Anna Lipinska, Morten Spange and Misa Tanaka
(292k)

This paper examines how the preferences of a large economy's central bank affect the trade-off between output and inflation volatility faced by the central bank of a small open economy by analysing the impact of a global cost-push shock. We demonstrate that under the assumption of producer currency pricing, the trade-off faced by the small open economy is likely to worsen as the foreign central bank becomes more focused on output stabilisation relative to inflation stabilisation; but the opposite is true in the case of local currency pricing.

Working Paper No 376
Endogenous choice of bank liquidity: the role of fire sales
Viral V Acharya, Hyun Song Shin and Tanju Yorulmazer
(878k)

Banks' liquidity is a crucial determinant of the adversity of banking crises. In this paper, we consider the effect of fire sales and entry during crises on banks' ex-ante choice of liquid asset holdings. We consider a setting with limited pledgeability of risky cash flows relative to safe ones and a differential expertise between banks and outsiders in employing banking assets. When a large number of banks fail, market for assets clears only at fire-sale prices and outsiders enter the market if prices fall sufficiently low. In such states, there is a private benefit of liquid holdings to banks from purchasing assets. There is also a social benefit since greater banking system liquidity reduces inefficiency from liquidation of assets to outsiders. When pledgeability of risky cash flows is high, for instance, in countries with well-developed capital markets, banks hold less liquidity than is socially optimal due to risk-shifting incentives; otherwise, banks may hold even more liquidity than is socially optimal to capitalise on fire sales. However, if there is a systemic cost associated with crises, for example, in the form of fiscal costs associated with provision of deposit insurance, then socially optimal liquidity may always be higher than the privately optimal one, and, in turn, regulation in the form of prudent liquidity requirements may be desirable. We provide some international evidence on banks' liquid holdings that is consistent with model's predictions.

Working Paper No 375
Inflation dynamics with labour market matching: assessing alternative specifications
Kai Christoffel, James Costain, Gregory de Walque, Keith Kuester, Tobias Linzert, Stephen Millard and Olivier Pierrard
(464k)

This paper reviews recent approaches to modelling the labour market, and assesses their implications for inflation dynamics through both their effect on marginal cost and on price-setting behaviour. In a search and matching environment, we consider the following modelling set-ups: right-to-manage bargaining versus efficient bargaining, wage stickiness in new and existing matches, interactions at the firm level between price and wage-setting, alternative forms of hiring frictions, search on-the-job and endogenous job separation. We find that most specifications imply too little real rigidity relative to the data and, so, too volatile inflation. Models with wage stickiness and right-to-manage bargaining, or with firm-specific labour emerge as the most promising candidates.

Working Paper No 374
How do different models of foreign exchange settlement influence the risks and benefits of global liquidity management?
Jochen Schanz
(429k)

Large, international banking groups have sought to centralise their cross-currency liquidity management: liquidity shortages in one currency are financed using liquidity surpluses in another currency. The nature of risks to financial stability emerging from global liquidity management depends on how these foreign exchange transactions settle. I analyse these risks in a game of asymmetric information. The main result is that the transition from local to global liquidity management, and better co-ordination in settlement of foreign exchange transactions, have two effects. On the one hand, the likelihood rises that payments are delayed beyond their due date. On the other hand, solvency shocks are less likely to be passed on to other banks. The main assumption is that lending between subsidiaries of the same banking group takes place under symmetric information, while external interbank market loans are extended under asymmetric information. More co-ordinated settlement increases the exposure of the intragroup lender relative to the interbank lender and leads to more informed lending.

Working Paper No 373
International financial transmission: emerging and mature markets
Guillermo Felices, Christian Grisse and Jing Yang
(979k)

With an increasingly integrated global financial system, we frequently observe that shocks to individual asset markets affect financial markets worldwide. The aim of this paper is to quantify the co-movements between bond markets in the US and emerging market economies using daily data from prior to the East Asian crisis through to the early stages of the current global financial crisis. We exploit the changing volatility of the data to fully identify a structural VAR, without imposing ad hoc restrictions. We find that shocks that widen emerging market sovereign debt (EMBIG) spreads have a negative effect on US interest rates in the short run (consistent with 'flight to quality' effects), while shocks that increase US interest rates raise EMBIG spreads over longer horizons (consistent with 'financing cost' or 'search for yield' effects). We also find that shocks that increase EMBIG spreads tend to widen US high-yield spreads and vice versa, constituting an important contagion channel through which crises in emerging market economies can affect mature markets. Forecast error variance decompositions show that shocks to US long rates can explain around 60%-70% of the variation of EMBIG and US high-yield spreads.

Working Paper No 372
Funding liquidity risk in a quantitative model of systemic stability
David Aikman, Piergiorgio Alessandri, Bruno Eklund, Prasanna Gai, Sujit Kapadia, Elizabeth Martin, Nada Mora, Gabriel Sterne and Matthew Willison
(934k)

We demonstrate how the introduction of liability-side feedbacks affects the properties of a quantitative model of systemic risk. The model is known as RAMSI and is still in its development phase. It is based on detailed balance sheets for UK banks and encompasses macro-credit risk, interest and non-interest income risk, network interactions, and feedback effects. Funding liquidity risk is introduced by allowing for rating downgrades and incorporating a simple framework in which concerns over solvency, funding profiles and confidence may trigger the outright closure of funding markets to particular institutions. In presenting results, we focus on aggregate distributions and analysis of a scenario in which large losses at some banks can be exacerbated by liability-side feedbacks, leading to system-wide instability.

Working Paper No 371
Payment systems, inside money and financial intermediation
Ouarda Merrouche and Erlend Nier
(569k)

We assess the impact of introducing an efficient payment system on financial intermediation. Two channels are investigated. Innovations in wholesale payments technology enhance the security and speed of inside money as a payment medium for customers and therefore affect the split between holdings of cash (outside money) and holdings of deposits (inside money). Second, innovations in wholesale payments technology help establish well-functioning interbank markets for end-of-day funds. This reduces the need for banks to hold excess reserves and thus helps credit creation. We examine these links empirically using payment systems reforms in Eastern European countries as our laboratory. We find evidence that reforms led to a 'crowding in' of cash in favour of demand deposits and that this in turn enabled a prolonged credit expansion in our sample countries. By contrast, while payment system innovations also led to a reduction in excess reserves in some countries, we do not find this effect was causal for the credit boom observed in these countries.

Working Paper No 370
Banks' intraday liquidity management during operational outages: theory and evidence from the UK payment system
Ouarda Merrouche and Jochen Schanz
(411k)

We investigate how settlement banks in CHAPS, the United Kingdom's large-value payment system, deal with operational risk. In particular, we are interested in payments behaviour towards a bank that is, for operational reasons, unable to make but able to receive payments. If other banks did not sufficiently monitor their outgoing payments, operational shocks could impact the entire payment system because the affected bank may absorb liquidity from the system. We first build a game-theoretic model in which a bank's decision to make payments depends both on whether another bank experiences operational problems, and on the time of day at which the outage occurs. We then investigate these reactions empirically using a non-parametric method. Our theory predicts that banks stop paying to a bank which has been unable to make payments early in the day, when they are uncertain about the payment instructions they might have to execute. When this uncertainty has been resolved (later in the day), healthy banks make payments even to a bank experiencing the operational problem. Both predictions are supported by the data. We show that this behaviour effectively contains the disruption caused by the operational outage: payment flows between healthy banks are largely unaffected.

Working Paper No 369
Multivariate methods for monitoring structural change
Jan J J Groen, George Kapetanios and Simon Price
(297k)

Detection of structural change is a critical empirical activity, but continuous 'monitoring' of time series for structural changes in real time raises well-known econometric issues. These have been explored in a univariate context. If multiple series co-break, as may be plausible, then it is possible that simultaneous examination of a multivariate set of data would help identify changes with higher probability or more rapidly than when series are examined on a case-by-case basis. Some asymptotic theory is developed for a maximum CUSUM detection test. Monte Carlo experiments suggest that there is an improvement in detection relative to a univariate detector over a wide range of experimental parameters, given a sufficiently large number of co-breaking series. The method is applied to UK RPI inflation in the period after 2001. A break is detected which would not have been picked up by univariate methods.

Working Paper No 368
The real exchange rate in sticky-price models: does investment matter?
Enrique Martínez-García and Jens Søndergaard
(400k)

This paper re-examines the ability of sticky-price models to generate volatile and persistent real exchange rates. We use a DSGE framework with pricing to market to illustrate the link between real exchange rate dynamics and what the model assumes about physical capital. We show that adding capital accumulation to the model facilitates consumption smoothing and significantly impedes the model's ability to generate volatile real exchange rates. Our analysis, therefore, caveats earlier work that has shown how real shocks in a sticky-price model without capital can replicate the observed real exchange rate dynamics. Finally, we find that so-called persistence anomaly remains robust to several alternative capital specifications including set-ups with variable capital utilisation and investment adjustment costs. In summary, the PPP puzzle is still very much alive and well.

Working Paper No 367
Labour market flows: facts from the United Kingdom
Pedro Gomes
(463k)

In this paper I use the Labour Force Survey to obtain stylised facts about worker gross flows in the United Kingdom. I analyse the size and cyclicality of the flows between employment, unemployment and inactivity. I also examine job-to-job flows, employment separations by reason, flows between inactivity and the labour force, flows into and out of public sector employment and flows by education. I decompose contributions of job-finding and job-separation rates to fluctuations in the unemployment rate. Although the job-finding rate has been more relevant over the past ten years, the job-separation rate was particularly important during the early 1990s recession.

Working Paper No 366
Common determinants of currency crises: role of external balance sheet variables
Mirko Licchetta
(915k)

This paper investigates the role of external balance sheet variables as determinants of currency crises in emerging market (EME) and advanced economies. A random effect probit model is used in a panel of 40 countries with monthly data over the January 1980-December 2004 period. The main results of the paper are as follows. First, size and, particularly, the composition of a country's external balance sheet are found to play an important role in the onset of crises. Second, EMEs seem to be more sensitive to external balance sheet variables than developed countries, and so too do economies with fixed or quasi-fixed exchange rate regimes. Third, further support is provided to standard theoretical explanations of currency crises. The likelihood of a crisis is found to increase with: the extent to which the real exchange rate rises above its trend; faster growth in broad money (relative to the level of international reserves); larger current account and budget balance deficits; lower GDP growth; and, if a neighbouring country already has a crisis. Economic fundamentals are also found to be a more important explanation of the onset of currency crises during the 1980s than during the 1990s, suggesting that more recent crises are less 'fundamentally' driven.

Working Paper No 365
Foreign exchange rate risk in a small open economy
Bianca De Paoli and Jens Søndergaard
(317k)

Resolving the forward premium puzzle requires a volatile foreign exchange rate risk premium that covaries negatively with the expected depreciation rate. Earlier work has shown how models featuring consumption habits can generate such premia when either trade costs or 'deep habits' are assumed. We show that as long as consumption habits are slow-moving and shocks are highly persistent, a standard small open endowment economy - without any additional features - can address the puzzle. Moreover endogenising the labour supply decision in the small open economy can improve the model's ability to match risk premia observations so long as it makes business cycles less synchronised.

Working Paper No 364
What lies beneath: what can disaggregated data tell us about the behaviour of prices?
Haroon Mumtaz, Pawel Zabczyk and Colin Ellis
(1.1mb)

This paper uses a factor-augmented vector autoregression technique to examine the role that macroeconomic and sector-specific factors play in UK price fluctuations at the aggregate and disaggregated levels. Macroeconomic factors are less important for disaggregated prices than aggregate ones. There also appears to be significant aggregation bias - the persistence of aggregate inflation series is much higher than the underlying persistence across the range of disaggregated price series. Our results suggest that monetary policy affects relative prices in the short to medium term, and that the degree of competition within industries plays a role in determining pricing behaviour.

Working Paper No 363
Dynamics of the term structure of UK interest rates
Francesco Bianchi, Haroon Mumtaz and Paolo Surico
(869k)

This paper models the evolution of monetary policy, the term structure of interest rates and the UK economy across policy regimes. We model the interaction between the macroeconomy and the term structure using a time-varying VAR model augmented with the factors from the yield curve. Our results suggest that the level, slope and curvature factors display substantial time variation, with the level factor moving closely with measures of inflation expectations. Our estimates indicate a large decline in the volatility of both yield curve and macroeconomic variables around 1992, when the United Kingdom first adopted an inflation-targeting regime. During the inflation-targeting regime, monetary policy shocks have been more muted and inflation expectations have been lower than in the pre-1992 era. The link between the macroeconomy and the yield curve has also changed over time, with fluctuations in the level factor becoming less important for inflation after the Bank of England independence in 1997. Policy rates appear to have responded more systematically to inflation and unemployment in the current regime. We use our time-varying macro-finance model to revisit the evidence on the expectations hypothesis.

Working Paper No 362
Output costs of sovereign crises: some empirical estimates
Bianca De Paoli, Glenn Hoggarth and Victoria Saporta
(220k)

Avoiding the broader output losses to their economy is likely to be the key reason why governments avoid debt crises. Despite this, there has been little work that seeks to quantify output losses associated with such crises. This paper seeks to fill this gap. We find that debt crisis episodes last for long - on average by about ten years - and are associated with large output losses (of at least 5% per year). Sovereign crises rarely occur in isolation - more often than not they are associated with currency crises or banking crises or both. It is the occurrence of a potent cocktail of 'twin' or 'triple' crises that is strongly associated with output losses rather than sovereign crisis per se.

Working Paper No 361
Why do risk premia vary over time? A theoretical investigation under habit formation
Bianca De Paoli and Pawel Zabczyk
(355k)

Empirical evidence suggests that risk premia are higher at business cycle troughs than they are at peaks. Existing asset pricing theories ascribe moves in risk premia to changes in volatility or risk aversion. Nevertheless, in a simple general equilibrium model, risk premia can be procyclical even though the volatility of consumption is constant and despite a countercyclically varying risk aversion coefficient. We show that agents' expectations about future prospects also influence premium dynamics. In order to generate countercyclically varying premia, as found in the data, one requires a combination of hump-shaped consumption dynamics or highly persistent shocks and habits. Our results, thus, suggest that factors which help match activity data may also help along the asset pricing dimension.

Working Paper No 360
Extracting inflation expectations and inflation risk premia from the term structure: a joint model of the UK nominal and real yield curves
Michael Joyce, Peter Lildholdt and Steffen Sorensen
(581k)

This paper analyses the nominal and real interest rate term structures in the United Kingdom over the fifteen-year period that the UK monetary authorities have pursued an explicit inflation target, using a four-factor essentially affine term structure model. The model imposes no-arbitrage restrictions across nominal and real yields, enabling us to decompose nominal forward rates into expected real short rates, expected inflation, real term premia and inflation risk premia. We find that inflation risk premia and longer-term inflation expectations fell significantly when the Bank of England was made operationally independent in 1997. The 'conundrum' of unusually low long-term real rates that began in 2004 is mainly attributed by the model to a fall in real term premia, though a significant part of the fall is left unexplained. The relative inability of the model to fit long real forwards during much of this recent period may reflect strong pension fund demand for index-linked bonds. Moreover, the model decompositions suggest that these special factors affecting the index-linked market may also partly account for the contemporaneous rise in longer-horizon inflation breakeven rates.