The granting of independence to the Bank of England following Labour’s victory in the 1997 UK General Election caused a collapse in inflation expectations. Whilst inflation expectations had been drifting down anyway, thanks mainly to globalisation and a demographic productivity boost, after independence was announced the 10 year breakeven inflation rate fell from 4% to 3.4% in just a couple of weeks. A year after independence, inflation expectations were down to 2.9%. See chart. With monetary policy out of the hands of politicians the long held view that the UK was a bit flakey on inflation faded away, and nominal bonds dramatically outperformed index-linked gilts.
Nowadays of course the UK has decent reserves of anti-inflation credibility (although funnily enough 30 year breakeven rates at 3.82% are nearly back at pre-independence levels), but we are definitely regarded as being a bit flakey on the fiscal side – just ask Bill Gross. At a gilt market lunch yesterday (hosted by BNP Paribas) former MPC member Tim Besley discussed his ideas for a fiscal policy committee (FPC) – “a politically neutral, expert body…that would assess the UK’s fiscal position”. As Besley’s blog states, other countries with similar fiscal councils “have reinforced government’s responsibility by raising the political costs of deviation”. After a post-election kitchen sink audit of the UK’s finances which finds that growth will be lower than forecast, off-balance sheet debt higher than declared and the cupboards bare, an incoming Conservative government can implement a VAT hike (which could take the annual RPI rate to 3.6% by the end of 2010) and buy fiscal credibility for the future by announcing the creation of a body like the FPC. Perhaps then we’d see a collapse in the UK’s CDS spread from its current level of 77 bps to something similar to France or Sweden (46 bps and 35 bps respectively)?