Bank of England Working Papers -
Abstracts 1996 (no. 42-57)
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The following are brief abstracts of working papers. Those papers that are out of print are marked as such (oop). For details of how to obtain copies of working papers, both in and out of print, see the Working Papers main page.
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 57
“Why do
the LIFFE and DTB bund futures contracts trade at different prices?”
Francis Breedong
The German Bund futures contract is the most important bond futures contract in Europe. It is also unusual in that it trades on competing Exchanges - LIFFE in London and the DTB in Frankfurt. This paper looks at a surprising aspect of this dually traded contract, namely that the contract trades slightly more expensively (1.5 basis points) in LIFFE than in the DTB. LIFFE argue that this price difference helps make their contract more attractive.
The paper investigates three possible explanations for the price difference. First, the calculation of price factors (conversion factors that make bonds in the basket of deliverables more comparable) differs slightly between Exchanges. Second, the DTB contract carries on trading for one day longer than the LIFFE one giving the short one more days to choose which bund in the basket to deliver (the so-called quality option) and so makes the contract slightly less valuable to the trader with a long position. Third, the penalty for late delivery is harsher on LIFFE than on the DTB and so investors fearing a short squeeze (where investors that are supposed to deliver the underlying bunds cannot acquire them) will be more nervous of holding a LIFFE contract than a DTB one.
It concludes that none of these factors are important enough to explain the observed price difference and so it is hard to explain why the price difference occurs.
Working Paper No 56
“Inflation Forecast Targeting: Implementing and Monitoring Inflation
Targets”
By Lars E O Svensson
The paper discusses the implementation of inflation-targeting across countries. It argues that the intermediate variable under an inflation target is, in effect, the inflation forecast. Such a regime is shown to confer benefits over other regimes, such as money and exchange rate targeting: in terms of the efficient implementation of policy; in terms of transparency; and in terms of the stabilisation of inflation and output.
Working Paper No 55
“The
information content of the short end of the term structure of interest
rates”
By Marco Rossi
Market determined interest rates are important indicators for monetary policy since they can give a measure of market expectations of future policy. Although previous work in the Bank has estimated yield curves from gilt prices and found that these give useful information about long-term expectations, the value of such yield curves at short horizons-below two years-is open to question. This paper analyses two related questions on short-term interest rate expectations:
- is there useful information in shorter-term interest rates and
- are some interest rates more informative than others?
In particular, it compares the relative performance of the short end of the Bank yield curve and traded LIMEAN rates at various maturities.¹
Its benchmark of comparison is a practical one-it assess, ex
post, how well the different measures predicted future shorter-term interest
rates (eg how well six-month interest rates predict three-month interest rates
in three months time). It finds that the yield curve contains some information
at short horizons but that it is less reliable than the information from LIMEAN
rates. This suggests that the current Bank approach of only analysing yield
curves above two- year horizons and using other information to measure
short-term interest rate expectations is probably correct.
¹Although interest rate futures are a widely used measure of market
expectations the information they contain is not directly comparable to the
yield curve.
Working Paper No 54
“Monetary
Policy Uncertainty and Central Bank Accountability”
By
Charles Nolan and Eric Schaling
There is a considerable academic literature on the relationship between Central Bank independence and inflation but the issue of Central Bank accountability and its effect of inflation performance has received very little attention. This paper looks at the issue of accountability in a simple theoretical model. Defining greater accountability as lower public uncertainty over the Central Bank's preferences, it shows that greater accountability will tend to be associated with improved inflation performance. This follows because, increased uncertainty will cause the public to raise their average inflation expectation, ceteris paribus. This can be thought of as a form of risk premium that the public add to their inflation expectations when they are uncertain about the Central Bank's future actions.
Given this result, the paper goes on to establish that a given level of inflation can be achieved by different combinations of accountability and independence. Greater accountability means that the same inflation outcome can be achieved at lower independence. The paper then suggests that this result accounts for the negative correlation between independence and accountability found in Briault, Haldane and King (Bank WP No. 49)
Working Paper No 53
“What
Determines the Short-run Output-Inflation Trade-off?”
By
Anthony Yates and Bryan Chapple
Using post-war data on 43 countries, this paper shows that the finding that the trade-off between inflation and output falls as inflation rises is quite robust. The implication is that the real effects of monetary policy might be greater as the economy moves towards price stability.
The paper also looks at whether economies should approach price stability quickly or slowly, and finds, in common with other research, that fast disinflations tend to cost less in terms of lost output.
Working Paper No 52
“Feasible
Mechanisms for Achieving Monetary Stability: a Comparison of Inflation
Targeting and the ERM”
Matthew B Canzoneri, Charles Nolan and
Anthony Yates
A literature has grown up around papers by Kydland and Prescott (1977) and Barro and Gordon (1983) which shows how governments have an incentive to inflate the economy (to generate extra output) then the private sector will anticipate this and the economy will stick at a high inflation equilibrium.
Walsh (1995) proposed a way round this - for the government to delegate monetary policy to an independent central bank working under a contract defined in terms of inflation. Walsh argued that the inflation bias in policy could be eliminated without interfering with the government's ability to stabilise output when it needed to.
This paper criticises Walsh's result showing that if there are political pressures on the real interest rates then the inflation bias might vary from period to period. The paper argues that it is not practical to write contracts for every period, so good contracts will interfere with stabilisation policy. Such a contract may be no better than other means of preserving credibility, like, for example, the ERM.
The paper discusses how close Walsh's contract is to the practice of inflation targeting; arguing that there is some, but by no means a complete, read-across from one to the other.
The paper also suggests that Walsh's solution to the credibility problem is not a solution at all. There is no obvious way that government can be made to enforce the contract, other than that they may be concerned about their reputations. In this respect, regimes like the ERM are more effective, since it is possible for those who stay in - at least in principle - to penalise those who renege by withdrawing associated benefits of membership.
Working Paper No 51
“UK Asset
Price Volatility Over the Last 50 Years”
By Nicola Anderson
and Francis Breedon
The paper analyses the volatility of UK equity, bond and treasury bill returns and the sterling/dollar exchange rate since 1945. It finds that the volatility of all these assets is on a declining trend after peaking in the late '70s. It seems that greater nominal and real macroeconomic stability are the most likely causes of the current declining trend. Volatility is, however, still significantly higher than in the Bretton Woods era. The authors find no evidence that asset price volatility has any consequences for real activity.
Working Paper No 50
“Unemployment persistence: Does the size of the shock matter?”
By Marco Bianchi and Gylfi Zoega
One of the stylized facts of unemployment is that shifts in its mean rate between decades and half-decades account for most of its variance. In this paper, the authors use a statistical analysis based on switching regression models and nonparametric density estimation techniques to identify the dates of infrequent changes in the mean of the unemployment rate series of 17 countries. They find that in most countries, unemployment persistence is small once the (infrequently) changing mean rate has been removed. The changes in the mean rate coincide with large annual changes in actual unemployment. The conclusion is that the observed persistence in unemployment appears to be consistent with unemployment hysteresis arising after large shocks to unemployment, but not after small changes. The result poses a challenge to theory, since most existing hysteresis models do not have this non-linearity property.
Working Paper No 49
“Independence and Accountability”
By Clive Briault,
Andrew Haldane and Mervyn King
Why have central banks become more accountable and transparent in recent years? This paper considers a set of analytical models of monetary policy institutions to shed light on this. One conclusion it reaches is that uncertainty - regarding the central bank's inflation preferences or about the underlying model of the world - can generate inflationary problems which transparency can help counteract. This offers one rationale for the current monetary policy framework in the UK.
The paper also constructs a quantitative index of accountability. This suggests that transparency has been pursued most actively by central banks with little independence and a low accrued stock of credibility. Again, this chimes with UK experience.
A shorter version of this paper is forthcoming in "Toward More Effective Monetary Policy" - proceedings of the Seventh Internal Conference sponsored by the Bank of Japan's Institute for Monetary and Economic Studies.
Working Paper No 48
“The
Construction of the Bank's new UK Commodity Price Index”
By
Andrew Logan and Lucy O'Carroll
Indices which represent weighted averages of the prices of 'basic' commodities are often used in analysing inflationary pressures. Because basic commodities are usually purchased for further processing, changes in their prices will affect producers' costs, and these changes may eventually be passed on to consumers. Although there are a variety of such indices to choose from, they tend to reflect world demand for commodities (which is dominated by US demand) and so do not reflect commodity price pressures from a purely UK point of view.
This paper presents a commodity price index which attempts to reflect UK commodity price pressures. It differs from other indices in three main ways. First, the weights used are based on UK demand for each commodity. Second, instead of using a sterling equivalent of world prices, the index uses prices actually paid in the UK and so allows for factors such as CAP administered prices. Third, its coverage of fuels is more comprehensive than most indices.
This index is already presented in the Inflation Report and an article describing it appeared in the August 1995 Quarterly Bulletin. The purpose of the Working Paper is mainly to outline the method for those who wish to replicate this index.
Working Paper No 47
“Measurement Bias in Price Indices: An Application to the UK's
RPI”
By Alastair Cunningham
The paper assesses the potential for systematic discrepancies between the measured RPI and an 'ideal' cost-of- living which, the paper argues, should be the target variable for monetary policy (note that the RPI does not claim to be a cost-of-living measure and so this discrepancy does not imply that the RPI is wrong). It identifies four main sources of potential bias. First, product substitution bias which is caused by consumers substituting away from relatively expensive items over time (given that the RPI is based on an annually fixed basket of goods it may overestimate the actual increase in the cost-of-living of consumers who actively substitute). Second, Outlet substitution bias which, in a similar way to product substitution bias, is due to consumers moving away from relatively expensive retail outlets. Third, quality adjustment bias which arises when price rises due simply to improved quality of goods are not fully removed from the RPI. Finally, new goods bias which comes about when new goods, whose price tends to fall, are not introduced into the index
Using the results of detailed studies from the US and Canada and combining these with available data in the UK the paper comes up with a 'guesstimate' range of overall bias in the UK of 0.35% to 0.8% percentage points per annum. (i.e. RPI inflation is 0.35% to 0.8% above cost of living inflation). However, this range does not represent the range of possible outcomes it simply reflects the range of results in the North American studies. In practice, there are a number of factors that these studies have not controlled for and so the possible range of the bias could be much wider than the range defined above.
Working Paper No 46
“A Market
for Intra-day Funds: Does it Have Implications for Monetary Policy?”
By Spencer Dale and Marco Rossi
The UK is due to move to a system of real-time gross settlement (RTGS) later this year. Although the decision to move to RTGS was based on prudential concerns, this paper considers whether it has any implications for the implementation of monetary policy. In particular, the move could, in theory, lead to the development of an intra-day funds market which in turn would imply the existence of intra-day interest rates.
Although the paper argues that such a market is unlikely to develop in the near term, it continues by developing a simple theoretical framework to analyse the intra-day funds market and the intra-day yield curve. The paper derives two main results from this model. First, intra-day interest rates of a given duration could be highly volatile, even in the absence of shocks, since rates will vary depending on how close to the end of the trading day the loan is taken out. Second, the provision of intra-day liquidity does not effect a central bank's ability to control one-day (or longer) interest rates. As long as intra-day loans have to be repaid at some point during the day, the Bank will retain control over the one-day interest rate. As a result, extending the opening hours of the intra-day market (i.e. the period over which the discount window is open) could help reduce Herstatt risk without unduly influencing monetary control.
Working Paper No 45
“Base
Money Rules in the UK”
By Andy Haldane, Bennett McCallum
¹ and Chris Salmon
This paper assesses the performance of a simple monetary policy rule - McCallum's rule. This rule targets nominal income using the monetary base as its instrument whilst making an allowance for any on-going changes in money velocity. The paper conducts a range of historical counterfactual simulation exercises to establish the likely impact on the UK economy of using such a rule over the period 1960 to 1994.
The paper finds that had the rule been followed over that period a far superior inflationary performance would have resulted. Moreover, this improved performance would not have come about at the expense of heightened output or base money variability.
The paper suggests that, while such a rule could never substitute for a more eclectic approach which uses a wider range of indicators, it could serve as a useful benchmark when assessing whether monetary policy is broadly "on track"; it is a effectively a dynamic M0 monitoring range. As such, the implied profiles from such a simple rule may help provide insurance against the type of "big" policy mistakes which the UK economy has been subject to over the last 25 years.
¹Carnegie-Mellon University, USA
Working Paper No 44 (oop)
“A
Comparison of Methods for Seasonal Adjustment of the Monetary Aggregates”
By Marco Bianchi
This paper compares the performance of a four methods of seasonal adjustment for monthly monetary aggregates . The methods compared are
- GLAS - the method currently employed by the Bank.
- STL - a recently developed flexible non-parametric adjustment method.
- X-11 ARIMA (a slightly modified version of X-11) an established adjustment method widely used by government agencies including the CSO.
- STAMP a more structural method of adjustment than the other three developed by Andrew Harvey of the LSE.
The paper compares these approaches against a number of criteria including the ability to give the best estimate of current data, the ability to deal with adding up constraints and trading day adjustments, and ease of use. Predictability perhaps, the paper finds that no one method does best on all criteria and so a simple conclusion on the best method cannot be drawn on the evidence of this paper. However, future work will seek to reach a conclusion about the most appropriate seasonal adjustment method for the Bank of England to apply to these series, drawing perhaps from the discussion generated by this paper.
Working Paper No 43
“International Bank Lending to LDCs - an Information-Based
Approach”
By Prasanna Gai
This paper presents a theoretical model of international bank lending that may explain "herd-like" behaviour in lending to LDCs. The model assumes that there is a central money-centre bank whose behaviour influences that of regional banks by virtue of the fact that the regional bank can observe the money-centre's lending before making a decision itself. Given this leader-follower relationship and the fact that neither bank has complete information about the borrower, the regional bank's lending behaviour will be influenced by the observed level of lending by the money-centre bank (since it infers some of the money-centre bank's banks information from this). However, since the money-centre bank knows that the regional bank is doing this it can manipulate the regional bank's behaviour by its own actions. Solving this model shows that lending is higher than is optimal (i.e. above what would occur under perfect information). Also, since the borrower realises that lending will be higher and related largely to the strategic interaction between two types of lender he need make less adjustment effort than under perfect information.
The paper also presents some informal evidence that this herd-like behaviour, excessive lending and insufficient adjustment occurred between 1979 and 1981 in LDC lending.
Working Paper No 42
“Bidding
and Information: Evidence from Gilt-Edged Auctions”
By
Francis Breedon and Joe Ganley
This paper looks in detail at pricing in Gilt Auctions. It compares the prices received at all auctions between May 1987 and February 1995 with both the When-Issued price (the pre-auction market for delivery of the auction stock) and the price of a comparable parent stock (when one existed). The paper finds a marked difference in performance between non-fungible stocks (when a parent exists but the tranche cannot be traded identically with the parent until a few weeks after the auction due to part payments and different first coupons) and fully-fungible stocks (when the parent and tranche trade identically from auction day). The average auction price received for non-fungible stock was significantly below both the When-issued price (about 13p per £100) and the adjusted parent price (about 24p per £100). In the case of fully fungible auctions there was no discernable price difference between auction stock, When-issued, or adjusted parent stock price.
Auction prices below comparable secondary market ones is a common result for Government debt auctions (similar results have been found for the US, Germany and Mexico). The explanation usually given is that uncertainty about the correct price leads bidders to shade down their bids. The paper examines this explanation and finds that although it can help explain the results for non-fungible auctions (measures of uncertainty seem to be correlated with the degree of price difference) it does not explain the markedly different results observed for fully-fungible auctions since the dispersion of bids for these auctions is no less than for non-fungible ones suggesting that some uncertainty still exists.
This is a slightly revised version of a paper that was
published in July 1995 as part of the
Debt Management Review.
