Central bank balance sheet policies and the market for reserves

Michael Kumhof and Mauricio Salgado-Moreno

While ‘unconventional’ balance-sheet policies like quantitative easing (QE) and quantitative tightening (QT) appear to have been successful, it is difficult to separate their macroeconomic and financial stability implications from those of other polices. Hence, in a recent paper, we develop a theoretical framework, focusing on the central bank’s liabilities, that sheds light on these implications. The key model feature is the inclusion of a detailed financial system with both heterogeneous banks and non-bank financial institutions that allows us to identify the transmission of QE/QT policies. Our framework provides guidance to policymakers interested in using new combinations of balance sheet and interest rate policies by highlighting the relevance of the interbank market and financial frictions in the transmission of balance sheet policies.

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Caring for the ‘future’

David Glanville and Arif Merali

Short term interest rate (STIR) futures are the bedrock of interest rate markets, used to price expectations of central bank policy rates and other UK rate derivative markets such as swaps and options (see Figure 1). They are key for the transmission of monetary policy and provide an avenue for interest rate risk hedging which is important for financial stability. Financial market liquidity usually worsens when volatility rises, however liquidity in the UK’s STIR futures during 2022 was especially poor. Liquidity in some metrics such as open interest and volumes has since improved as volatility has reduced, however our extensive market intelligence conversations suggest that many still believe there is further to go when looking ‘under-the-bonnet’ at another key metric, market depth. Volatility continues to play a role, but a reversion to publishing key data releases within market hours may help to build liquidity further.

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What caused the LDI crisis?

Gabor Pinter, Emil Siriwardane and Danny Walker

In September 2022 the interest rate on UK gilts rose by over 100 basis points in four days. These unprecedent market movements are generally attributed to two key factors: the 23 September announcement of expansionary fiscal policy – the so-called ‘mini-budget’ – which was then amplified by forced sales by liability-driven investment funds (LDI funds). We estimate that LDI selling accounted for half of the decline in gilt prices during this period, with fiscal policy likely accounting for the other half. Balance sheet segmentation and operational issues slowed capital injections into LDI funds by well-capitalised pension schemes, leading LDI funds to instead sell gilts. Our analysis shows that these frictions were most pronounced for pooled LDI funds. There are further details in an associated working paper.

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Futures under stress: how did gilt futures behave in the LDI crisis?

Joel Mundy and Matt Roberts-Sklar

When markets are volatile, liquidity tends to worsen. This makes it harder to intermediate buyers and sellers. We saw this during the 2022 liability-driven investment (LDI) stress, when the UK government bond (gilt) market exhibited extreme volatility. This illiquidity was also evident in gilt futures, derivatives that support functioning in the cash gilt market. Gilt futures are traded on an electronic orderbook, meaning we can examine liquidity metrics at very high frequency. Looking across a range of liquidity metrics for gilt futures, we find that liquidity was broadly unchanged following the Monetary Policy Committee’s (MPC’s) decision of 22 September 2022. But market functioning deteriorated heavily following the UK Government’s fiscal statement of 23 September and took a long time to recover.

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‘No one length fits all’ – haircuts in the repo market

Miruna-Daniela Ivan, Joshua Lillis, Eduardo Maqui and Carlos Cañon Salazar

Funding markets are crucial for healthy and active financial institutions, and consequently for everyone in the economy. The repurchase agreement (repo) market plays a key role in bank and non-bank financial institutions’ (NBFIs’) daily activities by facilitating short-term financing and risk hedging. In this post, we use novel Securities Financing Transaction Regulation (SFTR) data to highlight new, and corroborate previous, stylised repo haircut facts.

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The link between mortgage debt servicing burdens and arrears: is there a critical threshold?

Nuri Khayal and Jonathan Loke

Many households in the UK have seen their mortgage payments go up since mortgage rates started to increase in 2022. In the current environment of higher rates, the question of how much a household can comfortably spend on their mortgage payments before getting into financial distress is particularly relevant. This blog shows that households which spend a larger share of their income on mortgage payments are at a higher risk of being in arrears. But in contrast to pre-existing work on the subject, we do not find evidence of a critical threshold after which the risk increases much more sharply. These findings imply that changes in the indebtedness across the whole mortgagor population, not just the tail, matter for financial stability.

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Leverage finds a way: a comparison of US Treasury basis trading and the LDI event

Adam Brinley Codd, Daniel Krause, Pierre Ortlieb and Alex Briers

We both drive cars, but the US drives on the right while the UK drives on the left. We both walk, but we do so on sidewalks in the US and pavements in the UK. We both have asset managers, who want to take leveraged positions in interest rates. US asset managers had around US$650 billion of long treasury futures in June 2023. UK asset managers, in Autumn 2022, held around £200 billion in leveraged repo. However, the ways in which the financial system found willing lenders for these borrowers, and intermediated the risk through the system of market-based finance, differ.

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Quantifying the macroeconomic impact of geopolitical risk

Julian Reynolds

Policymakers and market participants consistently cite geopolitical developments as a key risk to the global economy and financial system. But how can one quantify the potential macroeconomic effects of these developments? Applying local projections to a popular metric of geopolitical risk, I show that geopolitical risk weighs on GDP in the central case and increases the severity of adverse outcomes. This impact appears much larger in emerging market economies (EMEs) than advanced economies (AEs). Geopolitical risk also pushes up inflation in both central case and adverse outcomes, implying that macroeconomic policymakers have to trade-off stabilising output versus inflation. Finally, I show that geopolitical risk may transmit to output and inflation via trade and uncertainty channels.

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Three facts about the rising number of UK business exits

Jelle Barkema, Maren Froemel and Sophie Piton

Record-high firm exits make headlines, but who are the firms going out of business? This post documents three facts about the rising number of corporations dissolving using granular data from Companies House and the Insolvency Service. We show that the increase in dissolutions that have already materialised reflected a catch-up following Covid and was concentrated among firms started during Covid. While these firms were small and had a limited macroeconomic impact, firms currently in the process of dissolving are larger. Their exit might therefore be more material from a macroeconomic perspective. We also discuss how the recent economic environment could contribute to further rises in dissolutions and particularly insolvencies in the future that could have more material macroeconomic impact.

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Flow of funds and the UK real economy

Laura Achiro, Gerry Gunner and Neha Bora

A flow of funds framework is a way of understanding and tracking the movement of financial assets between different sectors of the economy. This blog specifically analyses UK corporate and household sectoral flows from 2000 to the present and highlights how this framework can reveal useful trends and signals for policymakers about the real economy. For instance, the accumulation of debt in the pre-global financial crisis (GFC) era by households and corporates was a warning signal that indicated several potential risks and vulnerabilities in the economy, including overleveraging and asset price inflation.

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