Bank of England Quarterly Bulletin February 2000
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Bank of England Quarterly Bulletin February 2000 Volume 40 Number 1 Bank of England Quarterly Bulletin February 2000 Summary 3 Recent economic and financial developments Markets and operations 5 Box on interest rate option volatility 8 Box on new estimates of the term structure of real interest rates 15 Box on financial market conditions over the century date change 18 The international environment 23 Box on stock market and housing wealth effects on consumption in the United States 30 Sterling wholesale markets: developments in 1999 38 Box on merger of CGO and CMO with CREST 48 Research and analysis Recent developments in extracting information from options markets 50 Stock prices, stock indexes and index funds 61 Private equity: implications for financial efficiency and stability 69 Box on how leveraging ratchets up the returns on equity 73 Box on the risks from leveraging 74 Speeches Back to the future of low global inflation Speech by DeAnne Julius, member of the Bank’s Monetary Policy Committee, delivered as the Maxwell Fry Global Finance Lecture at the University of Birmingham on 20 October 1999 77 British unemployment and monetary policy Speech by Sushil B Wadhwani, member of the Bank’s Monetary Policy Committee, given to the Society of Business Economists on 2 December 1999 88 Before the Millennium: from the City of London Speech by the Governor at the first City of London Biennial Meeting, organised by City University Business School and held at the International Maritime Organisation on 7 December 1999 103 Volume 40 Number 1 Printed by Park Communications © Bank of England 2000 ISSN 0005-5166 The Quarterly Bulletin and Inflation Report Inflation Report The Inflation Report reviews developments in the UK economy and assesses the outlook for (published separately) UK inflation over the next two years in relation to the inflation target. The Report starts with a short overview section. The following four sections analyse developments in money and financial markets, demand and output, the labour market, and costs and prices respectively. The concluding sections present a summary of monetary policy since the November Report and an assessment of inflation prospects and risks. The Bank of England Agents’ Summary of Business Conditions is appended to the Report. Minutes of recent Monetary Policy Committee meetings are attached as an annex. Markets and operations This article reviews developments in international and domestic financial markets and (pages 5–22) describes Bank of England market operations in the period 30 September 1999 to 14 January 2000. The century date change passed with minimal disturbance to markets. Financial market turnover was generally low in December and corporate bond issuance fell, but activity rapidly returned to normal levels in early January. Official interest rates were raised in both the euro area and the United States in November, by 50 and 25 basis points respectively. During the period, yield curves in the euro area and the United States shifted upwards, largely in response to stronger-than-expected economic growth and in anticipation of further monetary policy tightening. Short-term market interest rates also rose in the United Kingdom, partly reflecting the MPC’s decisions to raise the Bank’s repo rate by 25 basis points in November and January. But long gilt yields fell, further accentuating the inversion of the gilt yield curve. Equity markets in all the major economies rose strongly during the period. The euro depreciated further against the other major currencies, despite higher market interest rates. The international This article discusses developments in the global economy since the November 1999 environment Quarterly Bulletin. World activity continued to expand at a faster-than-expected rate in the (pages 23–37) second half of 1999. Prospects for 2000 have improved and forecasts for GDP growth have recently been revised upwards. The US economy continued to grow strongly, driven 1 1 primarily by domestic demand. The Federal funds target rate was increased by /4% to 5 /2% 1 3 in mid-November, and by a further /4% to 5 /4% in early February. Activity in the euro area picked up in Q3 and appears to have remained robust in Q4. Conditions in the major euro-area economies improved, partly due to stronger export demand. The ECB raised its 1 1 1 main refinancing rate by /2% in early November and by a further /4% to 3 /4% in early February. The Japanese economy has started to improve. That reflects a supportive policy stance as well as an increase in exports. However, the outlook for private consumption and investment remains weak. The recovery in emerging market economies in 1999 was stronger than expected. Growth in Asia is expected to be stronger than in Latin America. Oil prices continued to rise, but growth in non-oil commodities prices was more muted. Although raw materials prices have risen in response to this, inflationary pressures further along the supply chain have been more subdued. Sterling wholesale Sterling wholesale markets grew by £800 billion in 1999, though much of this reflected markets increased market values rather than new issuance. Though the size of markets grew, (pages 38–49) liquidity in a number of core markets fell, reflecting both the retreat of risk capital following the global financial crisis of 1998 H2 and, in the gilt-edged market, reduced government borrowing and hence lower bond supply. The approach of the millennium date change also affected markets in 1999 H2, though liquidity and turnover in December turned out higher than many had expected. The Bank made two changes to its open market operations in 1999: a major permanent widening in the list of collateral eligible in OMOs; and, from October, the introduction of temporary three-month repos designed to help firms plan their liquidity over the year-end. 3 Bank of England Quarterly Bulletin: February 2000 Research and analysis Research work published by the Bank is intended to contribute to debate, and is not (pages 50–76) necessarily a statement of Bank policy. Recent developments in extracting information from options markets (by Roger Clews, Nikolaos Panigirtzoglou and James Proudman of the Bank’s Monetary Instruments and Markets Division). The Monetary Policy Committee is provided with information from options markets to quantify market uncertainty about the future course of financial asset prices. For short-term interest rates, this is shown in the Inflation Report’s blue fan chart. Similar information can be obtained from a wide range of other assets. This article compares the performance of alternative techniques for extracting information from options prices. Using a technique for estimating uncertainty about interest rates at a constant horizon a short way into the future, we consider how this uncertainty has evolved since the Bank was granted operational independence in May 1997. Stock prices, stock indexes and index funds (by Richard A Brealey, special adviser to the Governor on financial stability issues). In recent years, many UK investors have given up the quest for superior performance and have instead simply sought to match the returns on some broad market index. This has led to the suggestion that the growth in index funds has depressed the stock prices of those companies that are not represented in the index and has thereby increased their cost of capital. This effect may have been accentuated by the actions of fund managers, whose performance is compared with that of a market index and so who also have an incentive to avoid those stocks that are not included in the index. This paper argues that, in practice, these price effects are likely to be very small. In support of this view, the paper examines the price adjustments that occur when a stock is added to, or removed from, a stock market index. Private equity: implications for financial efficiency and stability (by Ian Peacock and Stuart Cooper of the Bank’s Domestic Finance Division). Private equity has become an important source of finance in recent years for firms wanting to undertake a major restructuring or capital investment. Previously, its increased use was mainly associated with the ‘back to basics’ policy of many large companies and the consequent sale of non-core subsidiaries. Private equity investment houses have, however, diversified into financing other types of transaction. In doing so, they have achieved some attractive rates of return on amounts invested, which has led to an increase in the funds at their disposal. This article describes the current state of the UK private equity market. It also considers the extent to which private equity promotes efficiency by facilitating the ‘shake-up’ of businesses, and whether the success of investment houses in attracting substantially increased funds for investment poses any threats to financial stability. Private equity comprises equity investment in all types of unquoted companies, whether provided by individuals, funds or institutions. The article concentrates on larger transactions (particularly management buy-outs and buy-ins of over £10 million), and excludes start-up and early-stage venture capital finance, which in effect forms a distinct market with different characteristics. The contents page, with links to the articles in PDF format, is available at www.bankofengland.co.uk/qb/f00qbcon.htm The speeches contained in the Bulletin can be found at www.bankofengland.co.uk/speeches 4 Markets and operations This article reviews developments in international and domestic financial markets and describes Bank of England market operations in the period 30 September 1999 to 14 January 2000. ● The century date change passed with minimal disturbance to markets. Financial market turnover was generally low in December and corporate bond issuance fell, but activity rapidly returned to normal levels in early January. ● Official interest rates were raised in both the euro area and the United States in November, by 50 and 25 basis points respectively.