Quarterly Bulletin 2012 Q3 | Volume 52 No. 3 Quarterly Bulletin 2012 Q3 | Volume 52 No. 3 Executive summary Recent economic and financial developments (pages 185–201) Markets and operations. The Markets and operations article reviews developments in financial markets covering the period between the previous Bulletin and 24 August 2012. Financial market sentiment continued to be dominated by concerns about the challenges facing the euro area. Against this backdrop, and in response to weaker prospects for global growth in the first part of the review period, policymakers around the world announced a number of measures aimed at providing additional support to the financial system and stimulus to their respective economies. Following these announcements, market sentiment improved in the second half of the review period. Some contacts, however, cautioned against placing much weight on this, given the seasonal lull in some financial markets during July and August, and the fact that many of the fundamental challenges facing the euro area remained. The article also describes the results of the May 2012 Money Market Liaison Group Sterling Money Market Survey and market intelligence on contacts’ responses to an increased need for collateral. Research and analysis (pages 203–52) RAMSI: a top-down stress-testing model developed at the Bank of England (by Oliver Burrows, David Learmonth, Jack McKeown and Richard Williams). Safeguarding financial stability is one of the Bank of England’s two core purposes. The Risk Assessment Model for Systemic Institutions (RAMSI) is a large-scale model of the UK banking sector that was developed at the Bank. It is designed to assess the solvency and liquidity risks faced by banks, and provides one way of evaluating the risks and vulnerabilities facing the financial system. This article offers an overview of RAMSI and describes how the results are generated and how the feedbacks within and between banks are modelled. It also illustrates its use, drawing on the example of the stress tests carried out and published as part of the IMF’s 2011 UK Financial Stability Assessment Program (FSAP). The results from RAMSI suggested that a severe global downturn would have had material impacts on UK banks’ profits and capital ratios, but that the UK banking system would have been resilient enough to withstand the scenario. The results are highly uncertain, however, and do not take into account changes in balance sheets, macroeconomic conditions or policy measures that have occurred since the FSAP was constructed in early 2011. They are therefore not an assessment of the current state of the UK banking system but are an illustration of the types of outputs that RAMSI can produce. What accounts for the fall in UK ten-year government bond yields? (by Rodrigo Guimarães). Policymakers care about financial market measures of interest rates because they matter for the transmission of monetary policy and because they can provide useful and timely information about the state of the economy. UK ten-year government bond yields have recently fallen to historically low levels — as have yields in some other major economies — and there has been substantial debate about what is driving these movements. This article uses work undertaken in the Bank to explain the developments in UK yield curves, with an emphasis on movements since the onset of the financial crisis. Real and nominal UK interest rates have fallen substantially from the start of the crisis, with implied inflation rates relatively unchanged. A model decomposition shows that risk premia account for less than a quarter of the fall in nominal yields relative to pre-crisis averages. Together with the fact that falls have been concentrated in short-maturity forwards, the most likely explanation is that ten-year spot yields are low because monetary policy is expected to remain loose for longer than in previous easing cycles. Despite the low level of real yields, the model estimates suggest that inflation expectations have not become less well anchored, with inflation risk premia, if anything, lower than prior to the crisis. Option-implied probability distributions for future inflation (by Tom Smith). People’s beliefs about future inflation affect price-setting and wage-setting, and so play a major role in determining the rate of inflation. It is important, therefore, for policymakers to take them into account when setting monetary policy. Several measures of central expectations for UK inflation are available, for instance from surveys of inflation expectations or from financial markets, and these are regularly monitored by the Monetary Policy Committee (MPC). But data on beliefs about the full distribution of possible inflation outturns is relatively scarce. One source of such data comes from a market which has recently developed in inflation options — financial instruments that allow investors to speculate on, or insure against, future inflation outturns. The prices of these options can be used to calculate implied probability density functions (pdfs), which summarise investors’ beliefs about the distribution of future rates of inflation. This article describes the inflation option market and outlines the technique developed at the Bank to produce the pdfs. The results suggest that investors’ uncertainty about UK inflation rose substantially during the financial crisis, particularly between three and seven years ahead, and has remained high ever since. It is likely that this higher uncertainty reflects investors’ beliefs that the volatility in inflation over the past five years will persist for at least the next few years. The Bank of England’s Real-Time Gross Settlement infrastructure (by Andrew Dent and Will Dison). Electronic payments and securities transactions are essential to the functioning of modern economies. To reduce risk in the financial system, many of the sterling interbank obligations arising from these transactions are settled in central bank money, the most risk-free asset in the economy, across accounts at the Bank. To further reduce risk in this settlement process, many high-value payments are settled in real time. For these purposes, the Bank operates the United Kingdom’s Real-Time Gross Settlement (RTGS) infrastructure. On an average day the infrastructure settles some £575 billion, equivalent to UK annual GDP every three days. This article explains the role of the RTGS infrastructure, how it operates, and why it is so important to reducing risk in the UK financial system and to fulfilling both of the Bank’s core purposes — maintaining monetary and financial stability. It also highlights forthcoming developments that will further improve the infrastructure’s efficiency and resilience. Reports (pages 253–69) The distributional effects of asset purchases In its report on the 2012 Budget, the Treasury Committee asked the Bank to explain the distributional consequences of the MPC’s asset purchase programme (often referred to as quantitative easing (QE)). Without the reduction in Bank Rate and the MPC’s asset purchases in response to the sharp downturn after the collapse of Lehman Brothers, economic growth would have been lower and unemployment higher. The benefits of this highly accommodative monetary policy have not been shared evenly across households, however. Largely reflecting the low level of Bank Rate, rather than QE, some households have received lower income on their deposits, while some have paid lower interest on their debt. QE pushed up asset prices, in part reversing the large declines in equity prices seen earlier in the financial crisis. For a fully-funded defined benefit pension scheme, asset purchases are likely to have had a broadly neutral impact. Similarly, QE is likely to have had a broadly neutral impact on the value of the annuity income that could be purchased with a personal pension pot. But some pension schemes have been adversely affected by the direct effects of QE, with defined benefit schemes that were already in substantial deficit before QE began being particularly affected. Those costs are more likely to be borne by shareholders and those in work, rather than by existing pensioners. Monetary Policy Roundtable This edition also contains a summary of the main points made by participants at the most recent Monetary Policy Roundtable hosted by the Bank of England and the Centre for Economic Policy Research, on 14 June 2012. Research work published by the Bank is intended to contribute to debate, and does not necessarily reflect the views of the Bank or of MPC members. Contents Recent economic and financial developments Markets and operations 186 Box Asset purchases 188 Box Operations within the Sterling Monetary Framework and other market operations 192 Box The Funding for Lending Scheme 195 Research and analysis RAMSI: a top-down stress-testing model developed at the Bank of England 204 Box The formation of the Financial Policy Committee 206 Box The baseline scenario 210 What accounts for the fall in UK ten-year government bond yields? 213 Box G-ADTSMs and the role of surveys 217 Box Assessing robustness of G-ADTSMs 221 Option-implied probability distributions for future inflation 224 Box Caps, caplets, floorlets and floors 226 The Bank of England’s Real-Time Gross Settlement infrastructure 234 Box Real-time gross settlement versus deferred net settlement 237 Box Liquidity recycling 240 Summaries of recent Bank of England working papers 244 – Bank behaviour and risks in CHAPS following the collapse of Lehman Brothers 244