To the lower bound and back: measuring UK monetary conditions

Natalie
Burr,
Julian
Reynolds
and
Mike
Joyce

Monetary
policymakers
have
a
number
of
tools
they
can
use
to
influence
monetary
conditions,
in
order
to
maintain
price
stability.
While
central
banks
typically
favour
short-term
policy
rates
as
their
primary
instrument,
when
policy
rates
remained
constrained
at
near-zero
levels
following
the
global
financial
crisis
(GFC),
many
central
banks
–
including
the
Bank
of
England
–
turned
to

unconventional
policies
to
further
ease
monetary
conditions.
How
can
the
combined
effect
of
these
policies
be
measured?
This
post
presents
one
possible
metric
–
a
Monetary
Conditions
Index
–
that
uses
a
data-driven
approach
to
summarise
information
from
a
range
of
variables
related
to
the
conduct
of
UK
monetary
policy.
We
discuss
what
this
implies
about
how
UK
monetary
conditions
have
evolved
since
the
GFC.

What
are
monetary
conditions?

The
idea
of
constructing
a
Monetary
Conditions
Index
(UK
MCI)
–
a
summary
metric
of
variables
related
to
the
conduct
of
monetary
policy
–
is
not
new.

Traditionally,

monetary
conditions
were
defined
as
a
combination
of
information
from
short-term
interest
rates
and
exchange
rates
(eg

Batini
and
Turnbull
(2000)).
Earlier
literature
on
MCIs
therefore
typically
focused
on
a
small
number
of
variables.

This
approach
has
become
less
defensible
as
many
central
banks
–
including
the
Bank
of
England
–
extended
their
toolkit
with
a
range
of
monetary
tools.
The
key
feature
of

more
recent
approaches
to
measuring
monetary
conditions,
therefore,
has
been
to
examine
a
wider
range
of
variables,
in
order
to
capture
information
about
tools
such
as

quantitative
easing
(QE)
and
forward
guidance,
which
aim
to
influence

longer-term
interest
rates.

Conceptually,
monetary
conditions
don’t
include
risky
assets
or
private
credit.
This
is
because
they
do
not
fall
within
the
category
of
variables
relating
to
the
conduct
of
monetary
policy,
as
they
are
likely
to
be
affected
by
credit
risk
premia.
These
would
be
relevant
for
measures
of
broader

financial
conditions.

It
is
important
to
stress
that
monetary
conditions
do
not
provide
a
direct
reading
of
a
central
bank’s
monetary
stance.
The
monetary
stance
describes
the
impact
of
policy
rate
today,
in
combination
with
expectations
of
future
policy
actions,
on
real
economic
activity
(February
2024
Monetary
Policy
Report).
Monetary
conditions
are
related
to,
and
influenced
by
changes
in
the
monetary
stance,
but
by
other
factors
too
(such
as
household
preferences
for
holding
bank
deposits).

Methodology

Our
approach
for
constructing
the
UK
MCI
is
similar
to
the
data-driven
approaches
of

Kucharčuková
et
al
(2016)
and

Choi
et
al
(2022).
We
estimate
a

Dynamic
Factor
Model
(DFM)
from
a
combination
of
the
policy
rate
–
which
was
constrained
for
a
prolonged
period
by
the
effective
lower
bound
(ELB)
on
nominal
interest
rates
post-GFC
–
with
a
wider
range
of
monetary
and
financial
variables.
We
extract
common
factors
driving
comovement
of
the
variables
in
our
data
set
and
construct
a
weighted
average
of
these
factors.
Weights
are
equal
to
the
proportion
of
overall
variance
that
each
factor
explains,
divided
by
its
standard
deviation.

This
data-driven
approach
avoids
imposing
priors
on
the
weights
(eg
relating
the
weights
to
the
impact
of
individual
variables
on
macroeconomic
outcomes),
which
seems
a
natural
benchmark.

We
use
monthly
data
since
1993,
after
the
UK
adopted
inflation
targeting.
Our
data
set
combines
both
price
and
quantity
variables
and
includes
three
main
variable
categories.

First,

interest
rates.
More
specifically,
Bank
Rate;
short-term
overnight
index
swap
rates
(up
to
three
years);
and
long-dated
gilt
yields
(up
to
20
years).
We
motivate
the
inclusion
of
interest
rates
across
the
yield
curve
as
these
are
directly
affected
by
policy
rates
and
QE
purchases,
and
likely
to
contain
useful
information
on
forward
guidance.

Second,
we
follow

Lombardi
and
Zhu
(2018)
by
including

monetary
aggregates
and
central
bank

balance
sheet
variables
to
provide
further
information
about
monetary
policy
operations.
Following

Kiley
(2020),
these
variables
enter
the
DFM
twice,
as
(log)
levels
and
as
year-on-year
changes,
to
account
for
stock
and
flow
effects
respectively.
It
is
debatable
whether
monetary
aggregates
and
balance
sheet
variables
provide
material
additional
information
about
the
real
economy
effects
of
monetary
policy,
over
and
above
their
impact
on
interest
rates
(see

Busetto
et
al
(2022)
and

Broadbent
(2023)).
Though
this
may
risk
double-counting,
to
the
extent
that
our
modelling
strategy
aims
to
let
the
data
speak
for
itself,
incorporating
monetary
aggregates
and
balance
sheet
variables
provides
useful
information
about
their
comovement
with
interest
rates.

A
key
question
is
how
to
treat
the
exchange
rate.
Some
MCIs
retain
the
exchange
rate
to
account
explicitly
for
policy
transmission
via
this
channel.
While
they
are
part
of
the
transmission
of
monetary
policy,
exchange
rates
are
not
seen
as
a
policy
instrument
by
the
Monetary
Policy
Committee
(MPC),
and,
importantly,
are
influenced
by
many
domestic
and
global
factors
which
may
not
be
informative
about
UK
monetary
conditions
(Forbes
et
al
(2018)).
On
those
grounds,
we
exclude
the
exchange
rate.
Sensitivity
analysis
suggests
its
inclusion
did
not
materially
change
the
empirical
results.

Results

To
give
a
sense
of
what
is
driving
changes
in
the
UK
MCI,
Table
A
summarises
the
estimated

factor
loadings
from
the
DFM,
as
well
as
the
weight
of
each
factor
in
the
UK
MCI.
The
factor
loadings
reflect
how
the
variables
are
weighted
together
within
each
factor,
as
well
as
the
correlation
between
the
variables
and
each
factor.
We
assign
a
positive
sign
to
Bank
Rate
across
all
factors,
so
that
increases
imply
tighter
monetary
conditions;
we
expect
a
negative
sign
on
monetary
aggregates
and
central
bank
balance
sheet
variables,
as
an
expansion
in
these
quantities
implies
looser
conditions.

Table
A:
Factor
loadings

Notes:
Factor
loadings
are
averaged
across
different
subcategories
of
variables.

Source:
Authors’
calculations.

The
factor
loadings
suggest
that
all
blocks
of
variables
have
a
significant
bearing
on
the
UK
MCI.
The
first
factor
–
which
explains
the
largest
share
of
common
variance
between
the
variables
–
is
mainly
driven
by
interest
rates,
the
stock
of
monetary
aggregates
and
balance
sheet
variables.
By
contrast,
the
rate
of
change
of
the
quantity
variables
is
the
main
driver
of
the
second
factor.
We
retain
the
first
three
factors,
which
explain
almost
90%
of
overall
variance
in
our
data
set.

Chart
1
plots
the
UK
MCI
in
the
bottom
panel
and
some
key
input
variables
that
feed
into
it.
To
interpret
the
UK
MCI,
note
that
it
is
normalised
by
subtracting
its
mean
and
dividing
by
its
sample
standard
deviation.
As
such,
we
place
less
weight
on
the

level
of
the
UK
MCI,
and
more
on
changes.
As

Batini
and
Turnbull
(2000)
highlight,
you
cannot
make
a
statement
about
degrees
of
tightness,
but
you
can
make
relative
statements,
such
as
whether
monetary
conditions
are
tightening
or
easing.

Chart
1:
UK
MCI
and
selected
input
variables

Notes:
The
index
is
expressed
in
standard
deviations
from
average.
Stalks
denote:
(I)
GFC;
(II)
EU
Referendum;
(III)
Covid-19;
and
(IV)
start
of
tightening
cycle.
Latest
observation:
November
2023.

Sources:
Bank
of
England,
Bloomberg
Finance
L.P,
Tradeweb
and
Bank
calculations.

Our
index
points
to
a
loosening
in
UK
monetary
conditions
during
previous
stimulus
episodes.
The
UK
MCI
drops
significantly
during
the
GFC
(Chart
1,
Stalk
I),
consistent
with
the
MPC’s
conventional
and
unconventional
monetary
policy
actions.
The
UK
MCI
also
suggests
monetary
conditions
eased
as
a
result
of
monetary
policy
actions
following
the
EU
Referendum
(Stalk
II)
and
Covid-19
(Stalk
III),
however
less
so
than
during
the
GFC.

During
the
recent
tightening
cycle
(Stalk
IV),
the
UK
MCI
increased
slightly
earlier
than
Bank
Rate,
reflecting
the
slowing
pace
of
QE
purchases
in
2021.
The
tightening
over
2021–23
was
driven
first
by
reduced
balance
sheet
flows,
and
then
moves
in
the
yield
curve,
first
at
the
short
end,
and
then
also
at
the
longer
end.
The
UK
MCI
also
suggests
that
monetary
conditions
have
loosened
slightly
since
peaking
in
September
2023.

It
is
important
to
keep
in
mind
that
the
UK
MCI
presented
here
is
a
statistical
construct
and
reflects
only
one
approach
to
measuring
monetary
conditions.
Our
modelling
strategy
is
designed
to
weight
together
variables
based
on
their
historic
comovement
with
each
other,
not
their
correlation
with
GDP
or
inflation.
Due
to
our
use
of
fixed
weights,
any

state-contingent
effects
of
policies
are
only
indirectly
captured
in
our
index,
to
the
extent
that
it
is
reflected
in
interest
rates.
That
said,
to
the
extent
that
monetary
conditions
transmit
changes
in
the
monetary
stance
to
the
real
economy,
it
is
plausible
that
our
UK
MCI
provides
some
information
about
future
macroeconomic
outturns.
Preliminary
analysis
is
consistent
with
this
view,
though
further
research
is
required
to
substantiate
the
relationship
between
monetary
conditions
and
the
macroeconomy.

Conclusion

The
UK
MCI
presented
in
this
post
provides
a
comprehensive
new
measure
of
UK
monetary
conditions,
which
synthesises
information
about
both
conventional
and
unconventional
policies.
Crucially,
our
measure
shows
material
variation
in
the
post-GFC
period,
when
Bank
Rate
was
constrained
by
the
ELB.
Indeed,
it
highlights
that
unconventional
policy
tools
supported
significant
loosening
in
UK
monetary
conditions
in
response
to
the
GFC
and
subsequent
stimulus
episodes.
Even
at
times
when
the
ELB
is
not
binding,
including
the
recent
tightening
cycle,
the
UK
MCI
provides
more
information
about
the
evolution
of
monetary
conditions,
faced
by
economic
agents,
than
a
sole
focus
on
Bank
Rate
would
suggest.

Given
that
unconventional
tools
are
now
an
established
part
of
the
monetary
toolkit,
further
research
into
monetary
conditions,
and
what
they
imply
for
macroeconomic
outcomes,
remains
important.

---

Natalie
Burr
and
Julian
Reynolds
work
in
the
Bank‘s
External
MPC
Unit,
and
Mike
Joyce
works
in
the
Bank’s
Monetary
and
Financial
Conditions

Division.

If
you
want
to
get
in
touch,
please
email
us
at [email protected] or
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comment
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