Quarterly Bulletin Autumn 2003 Bank of England Volume 43 Number 3 Bank of England Quarterly Bulletin Autumn 2003 Summary 255 Recent economic and financial developments Markets and operations 257 Box on issuance of HM Government US dollar bond 262 Box on adjustments to the Bank’s official operations in the sterling money markets 270 Research and analysis Trends in households’ aggregate secured debt 271 Box on structure of model 272 Public expectations of UK inflation 281 Non-employment and labour availability 291 The information content of regional house prices: can they be used to improve national house price forecasts? 304 Balance sheet adjustment by UK companies 315 Summaries of recent Bank of England working papers Implicit interest rates and corporate balance sheets: an analysis using aggregate and disaggregated UK data 327 A Merton-model approach to assessing the default risk of UK public companies 328 Forecasting inflation using labour market indicators 329 UK business investment: long-run elasticities and short-run dynamics 330 E-barter versus fiat money: will central banks survive? 331 Non-interest income and total income stability 332 Credit risk diversification: evidence from the eurobond market 333 Houblon-Norman essays Inflation targeting and the fiscal policy regime: the experience in Brazil 334 The optimal rate of inflation: an academic perspective 343 Reports The EU Financial Services Action Plan: a guide 352 Box on a Single Market in Financial Services: estimating the benefits 353 Box on FSAP measures 356 Box on the Lamfalussy process 359 Box on market experts’ views about the FSAP 362 Speeches Credit conditions and monetary policy Speech by Paul Tucker, executive director of the Bank of England and member of the Monetary Policy Committee, given to the Leeds Financial Services Initiative on 28 August 2003 366 The contents page, with links to the articles in PDF, is available at www.bankofengland.co.uk/qbcontents/index.html. Authors of articles can be contacted at [email protected]. The speeches contained in the Bulletin can be found at www.bankofengland.co.uk/speech/index.html. Volume 43 Number 3 Printed by Park Communications © Bank of England 2003 ISSN 0005-5166 Quarterly Bulletin—Autumn 2003 Markets and operations This article reviews developments since the Summer Quarterly Bulletin in sterling and (pages 257–70) global financial markets, UK market structure and the Bank’s official operations. Research and analysis Research work published by the Bank is intended to contribute to debate, and (pages 271–333) does not necessarily reflect the views of the Bank or of MPC members. Trends in households’ aggregate secured debt (by Rob Hamilton of the Bank’s Structural Economic Analysis Division). The aggregate level of households’ secured debt relative to their income has increased by about a quarter over the past five years, and has almost tripled since 1980. Using a simple model, this article concludes that much of this increase can be accounted for by the spread of homeownership and the fall in inflation (which has reduced the rate at which households’ real debt burden is eroded over time). However, the model is unable to account for the full extent of the recent increase in secured borrowing growth. The model also suggests that, because only a relatively small fraction of the housing stock changes hands each year, the aggregate level of debt responds relatively slowly to changes in house prices. So the recent increases in house prices could lead to continuing increases in the debt to income ratio over the next five to ten years. Public expectations of UK inflation (by Clare Lombardelli and Jumana Saleheen of the Bank’s Monetary Assessment and Strategy Division). Every quarter, NOP carries out a survey of the inflation expectations of the general public. This article illustrates how expectations vary according to individuals’ different circumstances, and tries to explain how these differences might occur. Non-employment and labour availability (by Jerry Jones, Michael Joyce and Jonathan Thomas of the Bank’s Structural Economic Analysis Division). According to the Labour Force Survey, about 20% (approximately 7.5 million) of the non-student working-age population were not in paid employment in 2002. Of these people about one in five were classified as unemployed, with the remainder labelled as ‘inactive’. Despite this categorisation, however, some groups in the so-called inactive population are as likely to move into employment as those classified as unemployed, so any comprehensive measure of labour availability needs to incorporate information on the characteristics of the non-employed pool as a whole. This paper describes the key trends in the demographic and skill structure of the non-employed population since the mid-1980s and contrasts them with those in employment. It also attempts to draw out the implications of these trends for overall labour availability, building on recent Bank research which models individual transition rates from non-employment into employment. The information content of regional house prices: can they be used to improve national house price forecasts? (by Rob Wood of the Bank’s Structural Economic Analysis Division). It is often suggested that house price movements in the South East lead, or even cause, movements in the rest of the United Kingdom. If this were the case then house price inflation in the South East would be useful when forecasting national house price inflation. There are plausible channels through which such a ‘ripple effect’ could operate. But tests for patterns of regional price changes consistent with the effect give mixed results. There is evidence that regional price 255 Bank of England Quarterly Bulletin: Autumn 2003 changes were consistent with the South East playing a leading role in the late 1980s/early 1990s, but not during other periods. So it is important to understand the nature of the shock to the housing market before concluding that a given house price change in London and the South East has implications for house prices in other regions. Balance sheet adjustment by UK companies (by Philip Bunn and Garry Young of the Bank’s Domestic Finance Division). Corporate debt levels in the United Kingdom are currently at an historically high level in relation to the market value of corporate capital. Empirical evidence discussed in this article suggests that this is unlikely to be an equilibrium position and that companies will continue to act so as to strengthen their balance sheets. Much of this adjustment is likely to occur through financial channels, such as reduced dividend payments or increased new equity issues, but it could also occur through more restrained capital investment. Illustrative simulations presented in the article suggest that adjustment tends to be gradual and that it may take several years for balance sheets to return to equilibrium. Houblon-Norman essays Inflation targeting and the fiscal policy regime: the experience in Brazil (by Francesco (pages 334–51) Giavazzi, Houblon-Norman Fellow and Professor of Economics at Bocconi University, Milan and Visiting Professor of Economics at the Massachusetts Institute of Technology). This article reviews the recent experience of Brazil showing that credit risk is at the centre of the mechanism through which a central bank might lose control of inflation. Brazil during 2002 came close to a situation where fiscal policy hindered the effectiveness of monetary policy. But in early 2003 a change in investors’ perception of the long-run fiscal stance brought the economy back to normal conditions, reducing credit risk, stabilising the exchange rate and, through these two variables, inflation expectations, inflation and the dynamics of the public debt. Brazil’s experience could thus offer useful lessons for other emerging market economies, which consider adopting inflation targeting as their monetary policy rule. The optimal rate of inflation: an academic perspective (by Peter Sinclair, Houblon-Norman Fellow and Professor of Economics at the University of Birmingham). In an economy free of all imperfections, inflation should be slightly negative. Prices should keep dropping, at the real rate of interest. Any higher rate of sustained inflation (or lower deflation) would reduce the benefits from holding real money. Central banks typically aim for modest positive inflation, however. This article explores five types of imperfection: inertia in nominal prices, the need for distorting taxes, market power for retail banks, the value of the option to cut nominal interest rates in bad times, and menu costs. It concludes that the combined effect of these imperfections is in practice likely to justify a small positive rate of inflation. Reports The EU Financial Services Action Plan: a guide. A Single Market in financial services (pages 352–65) has long been an EU objective. The integration of financial markets in the EU has progressed much further in wholesale than in retail financial services, with the latter still segmented largely along national lines. The Financial Services Action Plan (FSAP) consists of a set of measures intended by 2005 to fill gaps and remove the remaining barriers to a Single Market in financial services across the EU as a whole. This guide to the FSAP has been prepared by HM Treasury, the Financial Services Authority (FSA) and the Bank of England. The guide is intended to provide an introduction to the FSAP for the UK financial sector, corporate sector and consumer