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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Monetary policy in a gas-TANK

Jenny Chan, Sebastian Diz and Derrick Kanngiesser

In recent years, increases in global energy prices have posed significant challenges for net energy importers such as the UK or the euro area. In addition to the inflationary impact, increases in the relative price of energy imply a decline in real incomes for the energy importers. In this blog post, we introduce a macroeconomic model that captures the direct adverse effects on aggregate demand caused by energy price shocks (a notion that resonates with policymakers’ concerns, ie Schnabel (2022), Broadbent (2022), Tenreyro (2022), Lane (2022)). We show how the transmission of energy price shocks differs from other supply shocks, thereby contributing to a better understanding and more effective mitigation of the disruptions caused by energy price shocks.

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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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Forecast accuracy and efficiency at the Bank of England – and how forecast errors can be leveraged to do better

Derrick Kanngiesser and Tim Willems

This post describes a systematic way for central banks to employ past forecasts (and associated errors) with the aim of learning more about the structure and functioning of the economy, ultimately to enable a better setting of monetary policy going forward. Results suggest that the Monetary Policy Committee’s (MPC’s) inflation forecast has tended to underestimate pass-through from wage growth to inflation, while also underestimating the longer-term disinflationary impact of higher unemployment. Regarding the effects of monetary policy, our findings suggest that transmission through inflation expectations has played a bigger role than attributed to it in the forecast.

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Using sectoral data to estimate the trend in aggregate wage growth

Tomas Key

Nominal wage growth has increased markedly in the UK in recent years, reaching levels that haven’t been seen for more than 20 years. Although growth has moderated a little in recent months, it remains significantly above its pre-pandemic level. An assessment of whether this strong rate of wage growth will persist is a key input to the monetary policy decision, given the important link between the cost of labour and firms’ pricing decisions. In this post, I will outline a new measure of the trend – or underlying – rate of wage growth which is estimated using data from many different sectors of the economy and which can help with this assessment.

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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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Selling England (no longer) by the pound: currency-mismatches and the dollarisation of UK exports

Marco Garofalo, Giovanni Rosso and Roger Vicquery

Most international trade is denominated in dominant currencies such as the US dollar. What explains the adoption of dominant currency pricing and what are its macroeconomic implications? In a recent paper, we explore a rare instance of transition in aggregate export invoicing patterns. In the aftermath of the depreciation that followed the Brexit referendum in 2016, UK exporters progressively shifted to invoicing most of their exports in dollars, rather than in pounds. This was driven by firms more exposed to currency mismatches, eg exporting in pounds but importing in dollars before the depreciation. As a result of this aggregate transition to dollar pricing, a dollar appreciation now depresses demand for UK exports by twice as much than before 2016.

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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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