Expectation of Lower Inflation – Investors’ Chronicle
Inflation is mostly temporary – depending on the gilt market. The five-year inflation break-even point (the difference between conventional and indexed yields) is now 4.7 percentage points. This compares to a current retail price index (RPI) inflation rate of 9%, implying that markets are pricing in a sharp drop in inflation. In fact, by comparing the three-, four-, and five-year breakeven inflation rates, we can calculate the implied breakeven inflation rates for the 12 months through May 2026 and May 2027. For both years, it is 3.7%. If we take into account that RPI inflation is generally higher than consumer price index (CPI) inflation (on average by 0.9 percentage points per year over the past 10 years), this implies that the market expects CPI inflation to fall below 3%. This is above the Bank’s target, and above the Bank’s own forecast, but it’s not a big deal.
Which begs the question: what does the gilt market know about future inflation anyway?
My chart helps answer that. It plots five-year real annualized RPI inflation against the five-year break-even inflation rate five years prior. This shows that there were only two occasions when the market got inflation wrong.
One was in the 1990s, when inflation was significantly lower than expected. Initially, this was because the market underestimated the disinflationary effect of the early 1990s recession, but in the late 1990s it underestimated the extent to which cheap imports in from China would reduce inflation.
The other was during the financial crisis at the end of 2008 when the market feared deflation which never materialized.
On average, however, inflation has been close to breakeven inflation for much of this century. Since the Bank of England gained operational independence in May 1997, inflation has averaged only 0.2 percentage points above the equilibrium rate.
Which sounds impressive.
Except that the gilt market has been going very badly lately. In March 2017, he put annual RPI inflation for March 2022 at 2.8%. It turned out to be 9%. This is the biggest forecast error since records began in 1985. To some extent, this is forgivable; no one could have predicted then that utility bills would rise more than 20% in 2021, and much more this year.
What is more curious is that inflation has, on average, exceeded break-even inflation. In theory, it shouldn’t. Yields on indexed gilts are generally lower than those on conventional securities, not only because investors anticipate inflation, but also because they want to protect themselves from the danger of unexpected inflation. Inflation breakevens therefore include both pure inflation expectations and an inflation risk premium. This means that if inflation risk does not materialize, actual inflation should be consistently higher than past equilibrium inflation rates.
Which was often not the case.
One of the reasons for this is that commodity prices have at times exceeded expectations. There is a significant correlation between the evolution of the latter and inflation errors in the gilt market. When commodity prices rise sharply, as in the mid-2000s, actual inflation exceeds market expectations. And when they fall (as in the mid-2010s), inflation falls below expectations.
Also, the market underestimates the extent to which inflation rises at the onset of economic recoveries due to mismatches between supply and demand patterns. In 2010-2011, for example, there was a demand for software engineers but an oversupply of construction workers. And now there is a shortage of truck drivers but unemployed car mechanics. Such mismatches, rather than excess demand in general, can drive up inflation.
But they tend to fade as supply and demand eventually react to price signals: market forces often act, if not as quickly as people think.
Which gives us reason to believe in the gilt market’s current optimism regarding inflation. If these lags fade, not only will inflation fall, but also one of the historical causes of the market’s underestimation of it.
This leaves the main threat to its inflation expectations being the possibility of another spike in commodity prices. We cannot quantify the danger this poses because (as today’s surprisingly high inflation shows) markets cannot predict wars or political disruptions.
What we can say, however, is that in the absence of such risks, government securities market forecasts – while imperfect – are not enough for us to give credence to his belief that the inflation will fall sharply. Markets aren’t perfect and the future is largely unknowable to a single mind, but sometimes there is wisdom in crowds.