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Deflating the deflation myth

There is currently a huge economic fear of deflation. This fear is basically built on the following three pillars.

First, that deflation would result in consumers delaying any purchases of goods and services as they will be cheaper tomorrow than they are today. Secondly, that debt will become unsustainable for borrowers as the debt will not be inflated away, creating defaults, recession and further deflation. And finally, that monetary policy will no longer be effective as interest rates have hit the zero bound, once again resulting in a deflationary spiral.

The first point is an example of economic theory not translating into economic practice. Individuals are not perfectly rational on timing when to buy discretionary goods. For example, people will borrow at a high interest rate to consume goods now that they could consume later at a cheaper price. One can also see how individuals constantly purchase discretionary consumer goods that are going to be cheaper and better quality in the future (for example: computers, phones, and televisions). Therefore the argument that deflation stops purchases does not hold up in the real world.

The second point that borrowers will go bust is also wrong. We have had a huge period of disinflation over the last 30 years in the G7 due to technological advances and globalisation. Yet individuals and corporates have not defaulted as their future earnings disappointed due to lower than expected inflation.

The third point that monetary policy becomes unworkable with negative inflation is harder to explore, as there are few recent real world examples. In a deflationary world, real interest rates will likely be positive which would limit the stimulatory effects of monetary policy. This is problematic, as monetary policy loses its potency at both the zero bound and if inflation is very high. This makes the job of targeting a particular inflation rate (normally 2%) much more difficult.

What should the central bank do if there is naturally low deflation, perhaps due to technological progress and globalisation? One response could be to head this off by running very loose monetary policy to stop the economy experiencing deflation, meaning the central bank would attempt to move GDP growth up from trend to hit an inflation goal. Consequences of this loose monetary policy may include a large increase in investment or an overly tight labour market. Such a policy stance would have dangers in itself, as we saw post 2001. Interest rates that were too low contributed to a credit bubble that exploded in 2008.

Price levels need to adjust relative to each other to allow the marketplace to move resources, innovate, and attempt to allocate labour and capital efficiently. We are used to this happening in a positive inflation world. If naturally good deflation is being generated maybe authorities should welcome a world of zero inflation or deflation if it is accompanied by acceptable economic growth. Central banks need to take into account real world inflationary and deflationary trends that are not a monetary phenomenon and set their policies around that. Central bankers should be as relaxed undershooting their inflation target as they are about overshooting.

Under certain circumstances central banks should be prepared to permit deflation. This includes an environment with a naturally deflating price level and acceptable economic growth. By accepting deflation, central banks may generate a more stable and efficient economic outcome in the long run.


A Fed taper is on the table

The FOMC took markets and economists by surprise in September this year when the committee members decided to hold off from tapering and maintain its bond-buying programme at $85bn per month. Three months down the road and the consensus for the December meeting outcome is that the Fed will not reduce the pace of MBS or treasury purchases. Consensus has been wrong before; will it be wrong again tomorrow? We think it will be a closer call than many expect.

In our opinion, there are several good reasons for the Fed to taper very slowly. Firstly, inflation is a non-issue, below target and close to lows not seen for decades. Secondly, the 30 year mortgage rate has risen from 3.5% in May to around 4.5% today, impacting US housing affordability and already tightening policy for the Fed. Thirdly, there is continued concern that 2014 may bring a return of the political brinkmanship that characterised late September, with the US Treasury signalling that the debt limit will have to be raised by February or early March to avoid default. Ultimately, the Fed is nowhere near hiking the FOMC funds rate.

There is no doubt after the September decision that tapering is truly data dependent and in this sense, macro matters. Fortunately, Ben Bernanke has told us what economic variables he and the FOMC will be looking at a press conference in June. The Fed wants to see a broad based improvement in three economic variables – employment, growth and inflation – before reducing the scale of bond buying.

The table below shows that the data has improved across the board. Annualised GDP is stronger, the unemployment rate is lower and the CPI is only 1.2%. Other key leading economic indicators like the ISM and consumer confidence are higher while markets are in a remarkably similar place to where they were three months ago with the 10 year yield at 2.86%.

US macroeconomic indicators chart

After the surprise of September’s announcement, we believe that every FOMC meeting from here on out is “live” – that is, there is a good chance that the Fed may act to reduce its bond-buying programme in some way until it reaches balance sheet neutrality. A reduction in bond purchases is not a tightening of policy, we view it as a positive sign that policymakers believe that the US economy is finally healing after the destruction of the financial crisis. As I wrote in September, interest rate policy is set to remain very accommodative for a long time, even after balance sheet neutrality has been achieved.

Given the positive developments in the US economy over the past three months, the December FOMC announcement could announce a) a small reduction in bond buying and b) an adjustment of the unemployment rate threshold or a lower bound on inflation. Whatever the case, quantitative easing is getting closer to making its swansong.


Who is to blame for shrinking real wages in the UK? Nobody?

The squeeze on UK consumers through falling real wages has been regarded as a significant factor in the (until recently) anaemic economic recovery.  Employers have taken a good share of the blame for this – but is that fair?  Have employers deliberately kept earnings below inflation as a means of boosting their own profitability, or was this an unintended outcome of upside inflation shocks?

If we look at Eurostat’s nominal wage growth series in the UK since the credit crisis, it’s only in the last couple of years that nominal wage growth has been well below the Bank of England’s inflation target of 2%.  In 2008 nominal wage growth was 6.1%, 2009 1.8%, 2010 3.6%, and 2011 2.1%.

It’s only in 2012 that Nominal Wage Growth fell way below the BOE’s inflation target

And yet over those same years, Labour Productivity per Hour Worked (again Eurostat) was awful.  -1.2% in 2008, -2.3% in 2009, +1.1% in 2010, and +0.7% in 2011.  In other words companies appear to have, ex ante, attempted to compensate their workers for expected inflation, assuming that the Bank of England hit its inflation target, and have overcompensated them, ex post, for improvements in productivity.

Labour productivity has been very weak – and often negative

So has the problem for earnings been the unexpected inflation overshoot (since the credit crisis started CPI has been above the Bank’s 2% target in all but 6 months, in 2009), not the wage setting behaviour of companies? Had inflation come in at, or above target, workers would have been better off in real terms until 2012, and certainly better off than you might expect given the historically strong relationship between wage growth and productivity.  I’m not sure I’m blaming the Bank of England here either – to achieve the 2% inflation target, rates would have had to have been inappropriately high for the domestic demand conditions and the distressed balance sheet of the UK public and private sectors.  And productivity is weak in part because employment has been unexpectedly strong relative to the weakness of the economy.  So a low inflation, high productivity UK economy sounds nice – but in the circumstances would likely have only have been possible with a much deeper recession and higher unemployment rate.


The M&G YouGov Inflation Expectations Survey – Q4 2013

The M&G YouGov Inflation Expectations Survey for November shows that consumers in all countries surveyed expect inflation to rise from current levels in both one and five years’ time. In the UK, short-term inflation expectations fell over the quarter to 2.8%, following recent downward pressure on UK CPI. It may also suggest that the shock from recent increases in utility bills may be fading. Over five years, however, inflation is once again expected to rise to 3.0%, suggesting expectations for future inflation remain well anchored above the Bank of England’s (BoE) CPI target of 2.0%. We did not see the same spike in inflation expectations as in other recent inflation expectations surveys such as the Bank of England’s own survey, possibly as ours is more recent and was conducted between November 22-25.

In Europe, all countries surveyed with the exception of Switzerland, expect inflation to be equal to or higher than the European Central Bank’s (ECB) CPI target of 2.0% on both a one- and five-year ahead basis. All European Monetary Union (EMU) countries expect inflation to be higher in both one and five years than it is currently, while only two countries – Spain and Switzerland – anticipate it being less than 3.0% in 5 years’ time.

Comparing the results with those from earlier surveys reveals a number of noteworthy observations. Inflation expectations for one year ahead have fallen in all surveyed EMU countries since the start of 2013. This is unsurprising given the weak macroeconomic environment and the fact that commodity prices have declined by roughly 5.6% in the past three months. Consumers have also benefitted from a stronger euro, which has gained around 6.6% over the past year on a real effective exchange rate (REER) basis. Notably, short-term inflation expectations in France, Spain and Italy are now running well above their current inflation rates.

Survey respondents in Hong Kong show no signs of moderating their inflation expectations, which remain at a high level of 5.0% and 5.5% over one and five years, respectively. In Singapore, inflation expectations over one year are double current inflation (2%) whilst the five-year reading remains stable at 5.0%, as it has done throughout the course of 2013.

The findings and data from our November survey, which polled over 8,500 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.


The UK’s inflation outlook – the opportunity in inflation-linked assets

With inflation numbers in the UK moving back towards target and deflationary concerns prevalent in Europe, it is worth asking ourselves whether stubbornly high prices in the UK are a thing of the past. Whilst the possibilities of sterling’s strength continuing into 2014 and of political involvement in the on-going cost of living debate could both put meaningful downside pressure on UK inflation in the short term, I continue to see a greater risk of higher inflation in the longer run.

5 years of sticky cost-push inflation

The UK has been somewhat unique amongst developed economies, in that it has experienced a period of remarkably ‘sticky’ inflation despite being embroiled in the deepest recession in living memory. Against an economic backdrop that one might expect to be more often associated with deflation, the Consumer Prices Index (CPI) has remained stubbornly above the Bank of England’s 2% target.


One of the factors behind this apparent inconsistency has been the steady increase in the costs of several key items of household expenditure, together with the recent spike in energy prices which I believe is a trend that is set to continue for many years.

Rising food prices have been another source of inflationary pressure. Although price rises have eased in recent months following this summer’s better crops, I think they will inevitably remain on an upward trend as the global population continues to expand and as global food demands change.

Sterling weakness has also contributed to higher consumer prices. Although sterling has performed strongly in recent months, it should be remembered that the currency has actually lost around 20% against both the euro and the US dollar since 2007. This has meant that the prices of many imported goods, to which the UK consumer remains heavily addicted, have risen quite significantly.

Time for demand-pull inflation?

Despite being persistently above target, weak consumer demand has at least helped to keep UK inflation relatively contained in recent years. However, given the surprising strength of the UK’s recovery, I believe we could be about to face a demand shock, to add to the existing pressures coming from higher energy and food costs.

The UK’s economic revival has been more robust than many had anticipated earlier in the year. Third-quarter gross domestic product (GDP) grew at the fastest rate for three years, while October’s purchasing managers’ indices (PMIs) signalled record rates of growth and job creation. Importantly, the all-sector PMI indicated solid growth not just in services – an area where the UK tends to perform well – but also in manufacturing and construction. At the same time, the recent surge in UK house prices is likely to have a further positive impact on consumer confidence, turning this into what I believe will be a sustainable recovery.


Central bank policy…

Central banks around the world have printed cash to the tune of US$10 trillion since 2007 in a bid to stimulate their ailing economies. This is an unprecedented monetary experiment of which no-one truly understands the long-term consequences. There has been little inflationary impact so far because the money has essentially been hoarded by the banks instead of being lent out to businesses. However, I believe there could be a significant inflationary impact when banks do begin to increase their lending activities. At this point, the transmission mechanism will be on the road to repair, and a rising money velocity will be added to the increased money supply we have borne witness to over the last 5 years. Unless the supply of money is reduced at this point, nominal output will inevitably rise.

Furthermore, I am of the view that new Bank of England governor Mark Carney is more focused than his predecessor was on getting banks to lend. His enthusiasm for schemes such as Funding for Lending (FFL), which provides cheap government loans for banks to lend to businesses, is specifically designed and targeted to fix the transmission mechanism, by encouraging banks to lend and businesses to borrow. The same is true of ‘forward guidance’, whereby the Bank commits to keep interest rates low until certain economic conditions are met.

Perhaps most importantly, I continue to believe the Bank is now primarily motivated by securing growth in the real economy and that policymakers might be prepared to tolerate a period of higher inflation: this is the key tenet to our writings on Central Bank Regime Change in the UK.

…and the difficulty of removing stimulus.

With real GDP growth of close to 3% and with inflation above 2% at the moment in the UK, a simple Taylor Rule is going to tell you that rates at 0.5% are too accommodative. But it appears that policymakers are, as we suggest above, happy to risk some temporary overheating to guarantee or sustain this recovery. We believe that this is a factor we are going to have to watch in the coming years, as the market comes to realise that it is much harder to remove easy money policies and tighten interest rates than it was to implement them and cut them.

We witnessed a clear demonstration of this with the infamous non-taper event in September: as the data improved, Bernanke had to consider reducing the rate of monthly bond purchases. However, the combination of improved data and a potential reduction in the rate of purchases saw yields rise; ultimately higher rates saw policymakers state their concerns about what these were doing to the housing market recovery, and so we got the ‘non-taper’. I believe that there are important lessons to be learned from this example, and that policymakers are going to continue to lag the economic recovery to a significant extent.

Inflation protection remains cheap

Despite these risks, index-linked gilts continue to price in only modest levels of UK inflation. UK breakeven rates indicate that the market expects the Retail Prices Index (RPI) – the measure referenced by linkers – to average just 2.7% over the next five years. However, RPI has averaged around 3.7% over the past three years and tends to be somewhat higher than the Consumer Prices Index (CPI). At these levels, I continue to think index-linked gilts appear relatively cheap to conventionals.

Furthermore, this wedge between RPI and CPI could well increase in the coming months due to the inclusion of various housing costs, such as mortgage interest payments, within the calculation of RPI. The Bank of England estimates the long-run wedge to be around 1.3 percentage points, while the Office for Budget Responsibility’s estimates between 1.3 to 1.5 percentage points . If we subtract either of these estimates from the 5-year breakeven rate (2.7%), then index-linked gilts appear to be pricing in very low levels of CPI.

Current inflation levels may seem benign. However, potential demand-side shocks coupled with a build-up in growth momentum and the difficulty of removing the huge wall of money created by QE will pose material risks to inflation in the medium term. Markets have become short-sightedly focused on the near term picture as commodity prices have weakened and inflation expectations have been tamed by the lack of growth. This has created an attractive opportunity for investors willing to take a slightly longer-term view.

A reminder to our readers that the Q4 M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies is due out later this week . The report will be available on the bond vigilantes blog and @inflationsurvey on twitter.


Winners of our @inflationsurvey competition. The M&G YouGov Inflation Expectations Survey for 4Q 2013 will be released next week.

Beginning of November, we published a blog announcing the release of our Q4 YouGov Inflation Expectations Survey for early December. We are now in the final stages of collating and analysing the survey results and will publish the full report in the coming days on Twitter (@inflationsurvey) and our bond vigilantes blog. For those of you who are not aware (where have you been?!), the survey was created by M&G’s retail fixed interest team in partnership with YouGov. We ask over 8,000 consumers from the UK, Europe, Hong Kong and Singapore what their expectations are for inflation over the next 1 and 5 years. This has grown ever more important as central banks have sought to manage interest rate expectations through forward guidance.

The results of the Q3 Survey published last September as well as previous surveys are available here.

So congratulations to the 15 winners listed below, who were chosen at random amongst all our @inflationsurvey followers and who will each receive a copy of Frederick Taylor’s “The Downfall of Money”. We will DM each of you asking for your address so we can send you the book.

Simon Lander @simonlander01
Britmouse  @britmouse
Ian Burrows  @ian_burrows
Richard Lander  @richardlander
Iain Martin ‏  @_IainMartin
Morningstar UK ‏  @mstarholly
Brian Simpson ‏  @simpsob1
Amir Rizwan  @amirriz1
Tim Sharp ‏  @tm_sharp
Leanne Hallworth ‏  @leanneha41
Kevin Fenwick @kevinfenwick
Nico  @nicolocappe
qori nasrul ulum  @reme_dial
Alexander Latter  @AlexanderLatter
Ace AdamsAllStar  @AceAdamsAllStar


Competition: follow @inflationsurvey on Twitter to have a chance to win one of 15 copies of The Downfall of Money by Frederick Taylor

At the end of October, the Citigroup Inflation Expectations survey showed a record jump in UK inflation expectations. The medium term expectation for UK inflation rose from 3.3% in September to 3.9%, and the number of people expecting inflation over 5% also rose significantly. Inflation expectations have become increasingly important in the UK because, as part of Bank Governor Carney’s new forward guidance regime announced in August, the Bank can raise rates even if unemployment remains high if inflation expectations become “unanchored”. Of course the period when the Citigroup survey was conducted was one where the major UK energy suppliers had announced annual price hikes of around 10%, and this spike in inflation expectations may well not persist. But it will have worried the Bank, and the gilt market fell on the release of the data.

Whilst UK inflation was making the news for its potential to surprise on the upside, Europe faced a very different scenario. October’s euro area CPI reading came in at an annual rate of 0.7%, down from 1.1% in September and below the market’s expectations. A Taylor Rule would suggest that with inflation so far from the ECB’s target of 2%, the central bank should be aggressively easing monetary policy (beyond today’s 25 bps cut, and beyond the zero bound to include QE?).

The next M&G YouGov Inflation Expectations Survey for the UK, European and Asian economies will be released in December. These M&G YouGov surveys are based on the best practice methodology discussed by the New York Fed (for example asking people about inflation rather than “prices of things you buy” as that sort of question tends to make people think solely of milk, bread and beer). We also have a bigger data sample than many of the other inflation surveys. Finally we also ask some interesting supplementary questions on issues like government economic policy credibility. As inflation expectations become increasingly important to central banks we think that we need to pay more attention to them – to date they have been well anchored, despite money printing through QE, but if this changes then so will central bank behaviour.

The Q4 M&G YouGov Inflation Expectations Survey will be released through Twitter. Follow @inflationsurvey to get the release time and date, and also to access the detailed report in December. The feed will also tweet on other inflation surveys and measures of inflation expectations. We hope you find it useful.

To encourage you to follow @inflationsurvey and be first to get the survey results, everybody who does so (and existing followers) will be put into a draw to win one of 15 copies of Frederick Taylor’s The Downfall of Money. This is the story of Germany’s hyperinflation of the 1920s, where the Reichmark fell to 2.5 trillion to the US dollar, and the economy collapsed – arguably sowing the seeds of the Second World War.


Click here for terms and conditions.


Eurozone inflation surprises to the downside. ECB will grudgingly be forced to cut rates.

Last week saw year-on-year core inflation in the euro area fall from just over 1% in September to a two year low of 0.7% in October (see chart). Such a level is entirely inconsistent with the ECB’s definition of price stability as inflation “below but close to 2%”, and will likely be met with a downward revision to medium term inflation prospects and with it an ECB rate cut later this year.


The ECB will no doubt have monitored the recent steady appreciation of the euro (see chart), which has effectively acted as a tightening of policy and will likely have a disproportionately negative effect on the periphery. Coupled with the latest inflation data, the strengthening of the euro will no doubt increase calls from the doves on the Governing Council (who should be acutely aware of the rising risks of a Japanese-style deflationary trap) to run a more stimulative policy.


With little evidence of upward pressure on German wages, the internal devaluation required within the eurozone to facilitate a more competitive and balanced economic area has also been dealt a blow. Richard recently noted an improvement in euro area funding costs, and with it a stabilisation of broader economic data. However, this is from a very low base and the challenges that Europe continues to face should not be underestimated. Both unemployment and SME funding costs remain stubbornly high in the periphery and non-performing loans continue to move in the wrong direction (see chart). The ECB understandably wants to maintain pressure on politicians to deliver on structural reforms, and no doubt some harbour fears of leaving fewer policy tools at their disposal once they cut rates towards zero, but the risks of medium term inflation expectations becoming unanchored to the downside should be a wakeup call and a call to action!



How do house prices feed into inflation rates around the world? It’s important for central banks, and for bond investors.

After the collapse in real estate prices in many of the major developed nations during and after the Great Financial Crisis, housing is back in demand again. Strong house price appreciation is being seen in most areas of the US, in the UK (especially in London), and German property prices have started to move up. We’re even seeing prices rise in parts of Ireland, the poster child for the property boom and bust cycle. I wanted to take a quick look at what rising house prices do for inflation rates. Not the second round effects of higher house prices feeding into wage demands, or the increased cost of plumbers and carpets, but the direct way that either house prices, mortgage costs and rents end up in our published inflation stats. Also, the question about whether central banks should target asset prices is another debate too (there’s some good discussion on that here).


There is no simple answer to the question “how do house prices feed into the inflation statistics”. It varies not just from country to country, but also within the different measures of inflation within one geographical area. But given central banks’ rate setting/QE behaviour is determined by the published inflation measures it’s important to understand how house prices might, or might not, drive changes in those measures.

The US

“Shelter” is around 31% of the CPI which is used to determine the pricing of US inflation linked bonds (TIPS), but just 16% of the Core PCE Deflator, the measure that the Federal Reserve targets. The PCE is a broader measure, with much bigger weights to financial services and healthcare, so shelter measures therefore have to have a smaller weight in that measure. The CPI shelter weight looks high by international standards. For the Bureau of Labor Statistics, the purchase price of a house is not important except in how it influences the ongoing cost of providing shelter to its inhabitants. The method that the BLS uses to determine what those costs might be is “rental equivalence”. It surveys actual market rents, and augments this data by asking a sample of homeowners to estimate what it would cost them to rent the property that they live in (excluding utility bills and furniture). You can read a detailed explanation of this process here. In both the CPI and PCE, pure market rents are given around a quarter of the weight given to OER, Owners’ Equivalent Rent. There are problems with this – and not just with the accuracy of the homeowners’ rental guesses. Having rents and rental equivalence in the inflation data rather than a house price measure means that you can have – simultaneously – a house price bubble, and a falling impact from house prices in the inflation data. We’ve seen times when a speculative frenzy means house prices rise, but the impact of that speculation is overbuilding of property (just before the 2008 crash there was 12 months of excess inventory of houses in the US compared to a pre-bubble level of around 5 months) leading to falling rents. The reverse happened as the US recovered. House prices continued to tank, but because of a lack of mortgage finance more people were forced to rent, pushing up rents within the inflation data.

The UK

How house prices feed into the UK inflation data depends on whether you care about CPI inflation (which the Bank of England targets) or RPI inflation (which we bond investors care about as it’s the statistic referenced by the UK index linked bond markets). House prices directly feed into the RPI, but because house prices have little direct input into the CPI, the recent trend higher in UK property will lead to a growing wedge between the two measures – good news for index linked bond investors! The RPI captures house price rises in two ways – through Mortgage Interest Payments (MIPs) and House Depreciation. Mortgage payments will increase as the price of property rises, but they will most quickly reflect changes in interest rates. For example Alan Clarke of Scotia estimates that a hike in Bank Rate of 150 bps would feed almost immediately into the RPI, adding 1% to the annual rate. This is despite the trend in the UK for people to fix their mortgage payments. Housing Depreciation linked to UK house prices with a lag, and is an attempt to measure the cost of ownership (a bit like the BLS’s aim with rental equivalence) but has been criticized as overstating the cost of ownership in rising markets as house price inflation is almost always about land values accelerating rather than the bricks and mortar themselves. Land does not depreciate like other fixed assets (no wear and tear). Housing is very significant in the UK RPI, making up 17.3% of the basket (8.6% actual rents, 2.9% MIPs, 5.8% depreciation).

The UK’s CPI is a European harmonised measure of inflation. It only takes account of housing costs through a 6% weight on actual rents. There has never been agreement within the EU about how wider housing costs should be measured! Countries with high levels of home ownership have different views from countries with a high proportion of renters. Housing is around 18% of the expenditure of a typical person in the UK, so the Office of National Statistics regards the current CPI weight as a “weakness”. They therefore are now publishing CPIH, which includes housing on a rental equivalence basis (the same idea that the ONS measures “the price owner occupiers would need to rent their own home” as a dwelling is a “capital good, and therefore not consumed, but instead provides a flow of services that are consumed each period”). CPIH has a 17.7% weight to housing, but remains an experimental series, and plays no part in the official monetary targets.

The Eurozone

The European Central Bank targets CPI inflation, at or a little below 2%. As mentioned above the harmonised measure that Eurostat produces does not include any measure of housing other than actual rents, with a weight of 6%. If you think house price inflation (or deflation) is important for policymakers this low weighting has probably never mattered since the Eurozone came into existence. Although there have been pockets of very high house price inflation (Spain, Ireland, Netherlands) because the Big 3, Germany, France and Italy have had very little house price movement I doubt that a CPIH measure would be terribly different. We are, however, now seeing some upwards movements in the German residential property market in “prime” regions – albeit it as Spanish and Dutch house prices continue to freefall. It’s also important to note the range of importance of rents within the individual countries’ CPI numbers. For Slovenians it makes up 0.7% of their inflation basket, but for the Germans it is 10.2%.


Housing makes up 21% of the headline CPI. Like the US CPI the Japanese statistical authorities use a measure of an “imputed rent of an owner-occupied house” as well as actual rental costs. Again the imputed rents from owner occupiers (15.6%) dwarf the actual numbers from renters (5.4%) – aren’t these large weightings to imputed rents here and elsewhere a bit worrying? How would you homeowners reading this go about guessing a rent for your property? I’d only get close by looking at websites for similar places to mine up for rent nearby. Is that cheating?


So why does this matter? Well if there is no correlation between house price inflation and consumer price inflation then it probably doesn’t. But intuitively both the direct impact on wage demands of workers who see house prices going up, and the wealth effect on the consumption of those who see their biggest asset surging in value should be significant. Therefore central banks will be missing this if they use statistics where the relationship between house prices and their impact in those statistics is weak.



A little less conversation and a little more action. Gilts underperform and sterling rallies when the BoE speaks

“Now, much has been made of the upwards movements in market interest rates since our announcement of forward guidance and I would like to give you my perspective. There’s been a generalised upward movement in long term bond yields, across the advanced economies, including the UK, over the course of the past month.  The main common driver is speculation that the US Federal Reserve will soon reduce the pace of its asset purchases (and) …. liquid sovereign bonds of the world’s largest economies are close substitutes for each other”.

Bank of England Governor Mark Carney in the “Jake Bugg” speech, Nottingham, 28th August.

In other words, according to Mark Carney, gilts sold off because treasuries sold off. Personally I do not share this view, and feel some of the blame also lies with the Bank of England. Indeed, if we look at the aftermaths of the 4 occasions of Carney writing or talking about forward guidance (the August Inflation Report, the Nottingham Speech, the BoE Monetary Policy Committee Meeting, and at the Treasury Select Committee), we see that in each instance the pound appreciated markedly and gilts underperformed.

Put together, the result so far of forward guidance has therefore been a tightening in UK monetary policy – Governor Carney said last week that monetary policy has become more “effective” as a result of guidance.  Perhaps, but only if you thought the UK was overheating, and this does not appear to be his, or other MPC members’, position.

7th August: the Inflation Report is published.

The August Inflation Report contains the forward guidance that the Chancellor commissioned in the Budget.  It said that rates would be no higher than 0.5% until unemployment was down to 7%, and that the Asset Purchase Facility wouldn’t shrink.  But it contained the three killer knockouts – that you could ignore forward guidance if the Bank’s forecast of inflation rose to 2.5%, if market/consumer inflation expectations became unanchored, or if there were risks to financial stability as a result of low rates. The market focused on these knockouts rather than the unemployment promise. Sterling rallied and gilts underperformed both US Treasuries and German bunds.

Carney intervention 1 - Quarterly Inflation Report

28th August: the Nottingham speech.

There was no mention of the famous knockouts in this speech and the tone tried to be dovish.  But there was a repeat in both the performance of the currency (a rally) and the gilt market (an underperformance).  These same trends are also exacerbated when the Bank of England’s MPC makes its “no change” rate/QE announcement on 5th September without any attempt to reinforce the commitment to forward guidance.

Carney intervention 2 - Nottingham speech

Carney Intervention 3 - BoE MPC Meeting

12th September: the Governor and MPC members appear in front of the Treasury Select Committee.

Not so strong this one – there was a reaction initially from sterling, and to a lesser extent gilt spreads.  But they weren’t especially long lived.

So I have no sympathy for Mr Carney’s view that forward guidance isn’t working because of the adverse movements in the pesky international bond markets – gilts have underperformed both bunds and treasuries, and the appreciation in the pound suggests that the markets think that Carney’s central expectation of three years without a hike is wrong.   But in the Nottingham speech, Mr Carney also suggested that another explanation for rising gilt yields is that “the markets think that unemployment will come down to 7% more quickly than the Bank does…that would of course be welcome”.  This is credible.  We look at economic surprise indices, and it is clear that around the time of the publication of the August Inflation Report, the UK economic data started to not only surprise on the upside, but to be even more upwardly surprising than the (also better than expected) economic data coming out of both the Eurozone and the US.  It’s a combination of the lack of clarity around the knockouts (made worse at last week’s TSC – I recommend you go along to watch this live if you get the chance by the way) and an expectation that the Bank’s unemployment forecast is overly bearish.  Of course the rise in international yields is important, but it’s not the full story.

Carney Intervention 4 - Carney faces TSC

UK economic data stronger than in US and Europe

So the timing of sterling rallies and gilt underperformance around the time of Bank communications suggests that they ARE getting something wrong, and the grilling in front of the TSC did not go well.  If I were them I wouldn’t try to use open mouth policy to try to reverse the trends we’ve seen, as it could lose them more credibility were the markets not to react positively.  Doing something is another matter though, and could lead to a big reversal in the gilt and currency markets.  As UK economic data improves and surprises on the upside I doubt we’ll see anything yet – but we do need a little less conversation and a little more action.

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