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Anjulie-Rusius_100

Falling soft commodity prices are a piece of cake

Higher agricultural commodity prices at the start of the year raised concerns about the impact these could have on retail food prices, should the trend prove persistent. Fortunately, the price of soft commodities (coffee, sugar, wheat etc) appears to have decoupled from that of hard commodities (gold, silver, platinum etc) in recent months. Indeed, data from the last seven quarters indicate that the price of many agricultural commodities have actually fallen, as the chart below shows.

Slide1

Coffee prices are now at a five month low, after fears of a shortage of coffee beans from Brazil have receded. The supply of sugar has increased year-on-year, while wheat prices have also fallen due to increased harvests and easing crop concerns.

In order to gauge the collective effect of these changing agricultural commodity prices and how they could potentially feed through into UK inflation, I have constructed a simple cake index, teaming up Global Commodity Price data with some basic recipes from the BBC Good Food website. Given that sponge and individual cakes are two of the representative items included in the CPI 2014 basket of goods – and that food and drink items make up 11.2% of the overall CPI index – combining the commodities in this way gives an indication of how future changes might affect the average consumer.

The graph below shows the results of the cake index, demonstrating the change in various cake costs (since October 2012) versus the UK CPI (yoy %). What’s interesting is the generally downward trend of all cake indices in the last seven quarters. Sponge cake and plain scones look particularly good value in recent months, owing to the high proportion of wheat in their recipes. Apple cake unsurprisingly provides a price signal for its key ingredient (the price of apples has fallen 4% YTD), while coffee cake gives a less pronounced but similar effect. The good news – particularly for lovers of chocolate cake – is that despite the persistent increase in the cost of cocoa, the price of other cake constituents such as sugar, wheat and palm oil (used as a proxy for butter) have all fallen sufficiently to offset this, bringing the price of chocolate cake lower in recent months.

Slide2

Despite the recent June increase in CPI to 1.9% yoy, due to the lag between raw commodity prices and their general price level, we should perhaps expect to see deflation feeding into cake prices and the overall food constituent of CPI in the coming months. Therefore although it is unclear who exactly was the first to declare “let them eat cake!”, this person may have been on to something. Personally, I’d recommend the (relatively cheap) scones.

Ana_Gil_100

The reliability of market and consumer inflation expectations

After yesterday’s poor U.S. GDP number and despite Mark Carney’s seemingly dovish testimony before the Treasury Select Committee, the Bank of England is increasingly looking like it will be the first of the major central banks to hike rates. At this stage, the BoE can retain its dovish stance because inflation is not an issue. However, in an environment of falling unemployment, early signs of a pick-up in wage inflation, rising house prices and stronger economic growth, consumers and markets may increasingly begin to focus on inflation. In anticipation, we think now is a good time to compare the inflation forecasting performance of markets and consumers.

In the graphs below we have compared UK RPI bond breakevens (a measure of market inflation expectations) with the Bank of England’s Gfk NOP Inflation Attitudes Survey (i.e. a UK household survey with over 1900 respondents consisting of nine questions on expectations for interest rates and inflation). An important point to note is that the analysis compares realised inflation (% yoy) with what survey expectations and breakeven rates indicated 2 years before.

How reliable are inflation expectations?

The comparison presents a number of interesting results:

Unexpected deflation: Both the survey and breakevens underestimated actual RPI inflation outcomes between 2006-2008 (in other words, nobody anticipated the inflationary shock coming from higher commodity/energy prices).  In 2008, UK RPI was rising at an annual rate of 5.2% as high oil prices were feeding through into higher energy bills. Market and consumer inflation expectations largely ignored the higher inflation numbers, a sign the central bank inflation targeting credibility remained strong.

UK RPI turned negative in 2009 as the world plunged into recession and the BOE cut interest rates. The market eventually began to price in deflation but only after RPI turned negative. For example, in November 2008 the 2 year breakeven was -1.4%, the actual RPI print in November 2010 was 4.7%. Owing 2 year gilt linkers relative to conventional 2 year gilts directly after the financial crisis was a great trade.

Deflation (and recessions) appear particularly hard to forecast, for consumers and markets alike. This is because consumers and markets tend to anchor their future expectations off current inflation (and growth) readings.

Post-crisis unanchoring:  Consumer inflation expectations generally underestimated realised inflation up until the global financial crisis, and has overestimated it since then, a possible sign that the crisis-recession years may have affected consumer views on the BoE’s commitment to fight inflation. Between 2000 and 2009, 2 year-ahead expected inflation averaged 2.5%. Since 2009, it has averaged 3.4%, almost one percentage point higher; suggesting a lower level of confidence that price stability will be achieved and also reflecting the higher RPI prints post 2009.

Surprisingly similar forecasts: Breakeven and survey rates differed only slightly over the sample period, with the largest gap (400bps) opening up in October 2008 after the Lehman crash. This was probably caused by the forced unwind of leveraged long inflation trades combined with a huge flight to quality bid for nominal government bonds, which distorted the market implied inflation rate. The average differential through the period (excluding years 08-09) is just 8bps. Nevertheless, breakevens seem to track RPI better since consumer surveys are usually carried out on a quarterly basis whilst the former are traded and re-valued with higher frequency. This makes them better at capturing quick moves and turning points in inflation.

Future expectations: Over the next 2 years, both consumers and markets expect RPI to rise above the current level of 2.6%. With a 2.7% implied breakeven, 2-year gilt linkers look relatively inexpensive today.

Of course, breakevens are far from being a perfect measure of inflation, as they embed inflation and liquidity risks premia, but they do appear to be better predictors of future inflation relative to consumer surveys. That does not mean survey-based data does not provide us with useful information, and for this purpose we launched the M&G YouGov Inflation Expectations Survey last year (available here). Consumer inflation expectations affect a number of economic variables, including consumer confidence, retail spending, and unit labour costs. However, during inflection points, such as the one we may be going through at present and in a world of approaching shifts in monetary policy, the timeliness of breakevens could represent an advantage that makes it worthwhile to follow them carefully.

stefan_isaacs_100

Is Europe (still) turning Japanese? A lesson from the 90’s

Seven years since the start of the financial crisis and it’s ever harder to dismiss the notion that Europe is turning Japanese.

Now this is far from a new comparison, and the suggestions made by many since 2008 that the developed world was on course to repeat Japan’s experience now appear wide of the mark (we’ve discussed our own view of the topic previously here and here). The substantial pick-up in growth in many developed economies, notably the US and UK, instead indicates that many are escaping their liquidity traps and finding their own paths, rather than blindly following Japan’s road to oblivion. Super-expansionary policy measures, it can be argued, have largely been successful.

Not so, though, in Europe, where Japan’s lesson doesn’t yet seem to have been taken on board. And here, the bond market is certainly taking the notion seriously. 10 year bund yields have collapsed from just shy of 2% at the turn of the year and the inflation market is pricing in a mere 1.4% inflation for the next 10 years; significantly below the ECB’s quantitative definition of price stability.

So just how reasonable is the comparison with Japan and what could fixed income investors expect if history repeats itself?

The prelude to the recent European experience wasn’t all that different to that of Japan in the late 1980s. Overly loose financial conditions resulted in a property boom, elevated stock markets and the usual fall from grace that typically follows. As is the case today in Europe, Japan was left with an over-sized and weakened banking system, and an over-indebted and aging population. Both Japan and Europe were either unable or unwilling to run countercyclical policies and found that the monetary transmission mechanism became impaired. Both also laboured under periods of strong currency appreciation – though the Japanese experience was the more extreme – and the constant reality of household and banking sector deleveraging. The failure to deal swiftly and decisively with its banking sector woes – unlike the example of the US – continues to limit lending to the wider Eurozone economy, much as was the case in Japan during the 1990s and beyond. And despite the fact that Japanese demographics may look much worse than Europe’s do today, back in the 1990s they were far more comparable to those in Europe currently.

Probably the most glaring difference in the two experiences is centred around the labour market response. Whereas Eurozone unemployment has risen substantially post crisis, the Japanese experience involved greater downward pressure on wages with relatively fewer job losses and a more significant downward impact on prices.

With such obvious similarities between the two positions, and whilst acknowledging some notable differences, it’s surely worthwhile looking at the Japanese bond market response.

As you would expect from an economy mired in deflation, Japan’s experience over two decades has been characterised by extremely low bond yields (chart 1). Low government bond yields likely encouraged investors to chase yield and invest in corporate bonds, pushing spreads down (chart 2) and creating a virtuous circle that ensured low default rates and low bond yields – a situation that remains true some 23 years later.

Japan and Germany 10 year government bond yields

Japan and Germany corporate bond yields

As an aside, Japanese default rates have remained exceptionally low, despite the country’s two decades of stagnation. Low interest rates, high levels of liquidity, and the refusal to allow any issuers to default or restructure created a country overrun by zombie banks and companies. This has resulted in lower productivity and so lower long-term growth potential – far from ideal, but not a bad thing in the short-to-medium term for a corporate bond investor. With this in mind, European credit spreads approaching historically tight levels, as seen today, can be easily justified.

Can European defaults stay as low as for the past 30 years

Europe currently finds itself in a similar position to that of Japan several years into its crisis. Outright deflation may seem some way off, although the risk of inflation expectations becoming unanchored clearly exists and has been much alluded to of late. Japan’s biggest mistake was likely the relative lack of action on the part of the BOJ. It will be interesting to see what, if any response, the ECB sees as appropriate on June 5th and in subsequent months.

BoJ basic discount and ECB main refinancing rates

Though it is probably too early to call for the ‘Japanification’ of Europe, a long-term policy of ECB supported liquidity, low bond yields and tight spreads doesn’t seem too farfetched. The ECB have said they are ready to act. They should be. The warning signs are there for all to see.

ben_lord_100

Deflation spreading in Europe

The ECB has already demonstrated an unusually, and perhaps worryingly, high tolerance of low inflation readings, with no additional action having been taken despite Eurozone HICP at 0.5% year-on-year as inflation continues to fall in many countries.

(Dis)inflation

Why might this be? One reason might be that while it is very concerned about deflation, at this point in time the ECB does not have a clear idea of what the right tool is to relieve disinflationary pressure, or how to implement it. Another reason might be that it is not particularly concerned about the threat of disinflation and so is happy to wait for the numbers to rise.

With regards to the latter of these possibilities, Mario Draghi discussed the low inflation numbers in January in Davos as being part of a relative price adjustment between European economies, and as being an improvement in competitiveness. One implication from this argument has to be that the lowest inflation numbers are being seen only in the periphery, and that as a result the much needed price adjustment between periphery and core is starting to take place. The other implication from this argument is that the ECB is happy to let this adjustment happen.

The chart below, however, shows inflation in Germany, France, the Netherlands, Spain and Italy (which together make up around 80% of Eurozone GDP) in terms of constant tax rates on a headline basis. This is important because fiscal reforms can have significant impacts on inflation numbers, when perhaps these should be stripped out as being temporary and artificial. The most obvious example of this would be a country implementing a hike in VAT, in which case inflation will jump upwards for a period until the base effect is removed some time later. This chart, alarmingly, shows that Spain, Italy and the Netherlands are now all experiencing deflation on a constant tax basis. It also shows that France is close to the precipice, with inflation on this basis at 0.2% year on year.

(Dis)inflation at constant tax rates even worse

A further concern from the above two charts ties in to the ECB’s argument that the low inflation numbers in the periphery are a temporary phenomenon on a path to important and desirable internal adjustments to competitiveness. This argument might hold if the periphery is seeing low inflation, while the core is seeing stable, on-target or slightly above-target inflation that brings Eurozone inflation as a whole, to close to but below 2%. However, both the above charts show that the trend of disinflation is affecting more than just the periphery in isolation, and this calls Draghi’s competitiveness argument into serious question. The ECB might be well advised to get ahead of this worrying trend and act soon.

richard_woolnough_100

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.

anthony_doyle_100

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.

jim_leaviss_100

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.

anthony_doyle_100

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.

ben_lord_100

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.

Slide1

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.

Slide2

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.

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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

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