Quarterly Bulletin Spring 2006 Bank of England Volume 46 Number 1 Foreword Every three months, the Bank of England publishes economic research and market reports in its Quarterly Bulletin. This quarter, one article reports the key findings from a Bank-commissioned survey on the state of household finances. The Bulletin also considers the information on inflation expectations and real interest rates that can now be derived following developments in index-linked financial markets, and reviews the latest movements in sterling and global financial markets. The household financial position is an important influence on consumer spending. Recently, the Bank commissioned a survey asking households a range of questions about their assets, debts and income — the third on this issue in recent years. The key findings are reported in the article entitled The distribution of assets, income and liabilities across UK households: results from the 2005 NMG Research survey, by Richard Barwell, Orla May and Silvia Pezzini. The survey reveals that a small fraction of households accounted for a large proportion of the total assets owned, debts owed and income earned. The majority of households surveyed reported being comfortable with their financial position. But there were a small proportion of households in the survey who appeared to be in financial distress. These results are similar to those contained in the previous year’s survey. For some time, the Bank has used index-linked financial instruments to derive market-based measures of inflation expectations and real interest rates. But trading in inflation swaps and index-linked bonds has increased rapidly in recent years. As discussed in the article entitled New information from inflation swaps and index-linked bonds, by Matthew Hurd and Jon Relleen, there now exists an increasingly liquid global market for such instruments. This facilitates analysis of inflation expectations and real interest rates across countries. In the United Kingdom, the United States and the euro area, index-linked instruments currently appear broadly consistent with each central bank’s inflation objective of broad price stability. A downward drift in international long-term real rates has also been apparent over recent years. The regular Markets and operations article describes financial market developments since the previous Bulletin. It notes how asset prices across many financial markets have continued to rise during the past three months, with the price of risk remaining unusually low. There was a further decline in long-term government bond yields, driven by declines in global real interest rates. In sterling markets, real rates fell particularly sharply at very long horizons, possibly linked to heightened demand from UK pension funds. Charles Bean Chief Economist and Executive Director for Monetary Policy, Bank of England. i Bank of England Quarterly Bulletin: Spring 2006 This edition of the Quarterly Bulletin also includes: G Understanding the term structure of swap spreads (by Fabio Cortes). Market expectations of the future path of interest rates can be derived from both government bond and swap yield curves. But, at times, these can provide different signals about market views. This article investigates the factors that contribute to the gap between government bond rates and swap rates at different maturities; G The information content of aggregate data on financial futures positions (by Caroline Mogford and Darren Pain). This article examines the empirical link between speculative financial futures positions and movements in asset prices; and G The forward market for oil (by Patrick Campbell, Bjorn-Erik Orskaug and Richard Williams). This article explores the working of the forward market for oil and considers why producers have not been hedging more of their future oil production. 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. ii Bank of England Quarterly Bulletin Spring 2006 Recent economic and financial developments Markets and operations 3 Box on pension fund valuation and liability driven investment strategies 8 Box on recent developments in UK pension fund regulation 10 Box on a simple model for emerging market bond spreads 14 Box on the Bank’s long-term repo operations 22 Research and analysis New information from inflation swaps and index-linked bonds 24 Box on estimating an inflation forward curve from inflation swap rates 27 The distribution of assets, income and liabilities across UK households: results from the 2005 NMG Research survey 35 Box on interpreting data from the NMG Research survey 38 Understanding the term structure of swap spreads 45 The information content of aggregate data on financial futures positions 57 Box on possible links between futures positions and movements in asset prices in spot markets 60 The forward market for oil 66 Box on what explains the shape of commodity futures curves? 70 Summaries of recent Bank of England working papers Modelling manufacturing inventories 75 The New Keynesian Phillips Curve in the United States and the euro area: aggregation bias, stability and robustness 76 Modelling the cross-border use of collateral in payment systems 77 Assessing central counterparty margin coverage on futures contracts using GARCH models 78 The price puzzle: fact or artefact? 79 MPC speeches The Governor’s speech in Ashford, Kent Speech at a dinner for Kent Business Contacts in conjunction with the Kent Messenger Group/Kent Business, delivered on 16 January 2006 80 Reform of the International Monetary Fund This is an edited version of the speech delivered by the Governor at the Indian Council for Research on International Economic Relations (ICRIER) in New Delhi, India on 20 February 2006 83 Global financial imbalances Speech by Rachel Lomax, Deputy Governor responsible for monetary policy and member of the Monetary Policy Committee, delivered at the Chatham House conference on Global Financial Imbalances, Chatham House, London on 24 January 2006 90 Monetary policy, demand and inflation Speech by Stephen Nickell, member of the Monetary Policy Committee. A shortened version of this speech was given at a private lunch in London for contacts of the Bank of England’s South East and East Anglia Agency on 31 January 2006 95 Has oil lost the capacity to shock? Speech by David Walton, member of the Monetary Policy Committee, given to the University of Warwick Graduates’ Association Senior Directors’ Forum on 23 February 2006 105 The contents page, with links to the articles in PDF, is available at www.bankofengland.co.uk/publications/quarterlybulletin/index.htm. Authors of articles can be contacted at [email protected]. The speeches contained in the Bulletin can be found at www.bankofengland.co.uk/publications/speeches/index.htm. Except where otherwise stated, the source of the data used in charts and tables is the Bank of England or the Office for National Statistics (ONS) and all data, apart from financial markets data, are seasonally adjusted. Volume 46 Number 1 Markets and operations This article reviews developments since the Winter Quarterly Bulletin in sterling and global financial markets, in market structure and in the Bank’s balance sheet.(1) G Short-term sterling market interest rates fell, while short-term US dollar and yen market rates increased, as market participants revised upwards their expectations for official rates in these currencies. G At longer horizons, real forward interest rates declined across the major currencies. At very long maturities, sterling real forward rates fell by more than rates in other currencies, possibly reflecting heightened demand by UK pension funds to match their expected liabilities with long-dated fixed income assets. G Global equity prices rose and credit spreads narrowed, suggesting that investors’ appetite to take risk remained strong. G In January, as a further step towards the planned introduction of reforms to the Bank’s operations in the sterling money markets, the Bank began lending using longer-term repos at market-determined interest rates. The global economy continued to grow robustly, with There was also evidence of market participants looking upward revisions to forecasters’ views on future GDP to invest in a wider range of assets. In particular, there growth in the euro area and Japan (Chart 1). Against were sizable inflows into commodities and emerging this backdrop, global financial asset prices generally market assets. rose (Table A). Credit spreads narrowed, equity indices increased and volatility in many markets remained low. Loan markets remained buoyant with companies able to borrow on more favourable terms. Perhaps reflecting Chart 1 this, leveraged buyout activity remained high. Expected real GDP growth for 2006 (a) Per cent 4.0 There were some differences in behaviour across investor types over the period. In particular, trustees United States 3.5 and corporate sponsors of defined benefit pension funds 3.0 in the United Kingdom, and to a lesser extent elsewhere, United Kingdom 2.5 have been looking to match better the characteristics of 2.0 their assets with their expected liabilities. As a result, Euro area these investors may have become more averse to holding 1.5 Japan risky assets with high and visible short-term price 1.0 volatility. At the same time, they may have become more 0.5 willing to accept lower returns on long-dated 0.0 government bonds, the cash flows on which better Jan. Mar. May July Sep. Nov. Jan. 2005 06 match those on their expected liabilities. In turn, this Source: Consensus Economics. may have contributed to further falls in long-term (a) Observations on and to the left of the line were available at the time of previous Bulletin. risk-free interest rates. (1) The period under review is 18 November 2005 (the data cut-off for the previous Quarterly Bulletin) to 17 February 2006. 3 Bank of England Quarterly Bulletin: Spring 2006 Table A February), the majority of economists expected the next Summary of changes in market prices move in sterling rates to be down.