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.

Ana_Gil_100

The M&G YouGov Inflation Expectations Survey – Q2 2014

Today we are launching the next wave of the M&G YouGov Inflation Expectations Survey which aims to assess consumer expectations of inflation over the short and medium term.

With interest rates at multi century lows, central banks continue to inject large amounts of monetary stimulus into the global economy. Recent inflation rates in the US, UK and Germany have proved central to the current market focus, as actions from policymakers have become increasingly sensitive to inflation trends.  This is true for the Fed and the BoE, as markets assess their possible exit strategies/timing, but especially for the ECB, whose last round of action is perceived to have been largely motivated by disinflationary pressures in the Euro area. In that context, market focus on inflation expectations has increased.

The results of the May 2014 M&G YouGov Inflation Expectations Survey suggest that both short and medium-term inflation expectations remain well anchored across most European countries.

Short-term expectations have risen from 2% to 2.3% in the UK as the country showed further signs of economic growth and reaccelerating wage pressure. On the other hand, inflation expectations for German consumers moderated in the last quarter as the downward trend in German HICP (1.1% YoY in April) may have added to the expectation that German inflation will remain subdued over the next year.

The general downward trend in short-term inflation expectations seems to have largely receded in all EMU countries and the UK. This may be somewhat surprising with much of Europe still experiencing low and falling inflation.

Inflation expectations – 12 months ahead

Over the medium term, inflation expectations remain above central bank targets in all countries surveyed, suggesting that consumers may lack confidence in policymakers’ effectiveness in achieving price stability. Over 5 years, UK inflation is expected to remain well anchored at a remarkably stable 3%. Despite recent low inflation rates across Europe, the majority of consumers in France, Italy and Spain continue to view inflation as a concern, and long-term expectations in those countries has risen back to 3%.

Inflation expectations – 5 years ahead

The findings and data from our May survey, which polled over 8,700 consumers internationally, is available in our latest report here or via @inflationsurvey on Twitter.

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The UK electoral cycle is alive and kicking

Yesterday’s UK Budget had one major surprise, the relaxation of rules regarding drawing down your pension. This means that from April 2015 you can draw down your pension pot in one go, to do with it as you wish. This policy move chimes with the coalition’s beliefs that one should take responsibility over one’s own finances. However, like all political decisions there may well be an ulterior motive behind the timing of this decision.

We talked previously about why a dovish central banker appointment at the Bank of England was politically expedient two years ahead of the May 2015 election. The current government had its last opportunity yesterday to add a last feel-good give away Budget to enhance the economy and its own electoral prospects. At first glance, what has it achieved with its surprise change in pension policy?

It has potentially released a huge wave of spending commencing April 2015. This will obviously make people feel wealthy as the cash literally becomes theirs as opposed to being locked away for a rainy day. The economic effect looks as though it would be too late to boost the economy ahead of the 2015 general election. However it is highly likely that the forthcoming pension pot release will be taken into account. Holidays would be booked ahead of the windfall, cars could be purchased, redecorating done, and Christmas presents bought as the promise of money tomorrow means you can run down saving and consume today. This pension release scheme will spur growth in the UK ahead of the election.

The particular neat trick of this policy change is that it is a giveaway Budget measure at no cost. This is because it is not the government giving away money, but it is simply giving people access to their own money. Fiscal stimulus at no cost, combined with low rates and a strong government sponsored housing market means the UK will continue to have a relatively strong economy.

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Should the Bank of England hike rates?

Many of us have become accustomed to a world of ultra-low interest rates and quantitative easing (QE). Taking into account inflation, real short-term interest rates are negative in most of the developed world. Of course, these historically low interest rates were a central bank response –co-ordinated on some occasions – to the Great Financial Crisis of 2008. Whilst we are still waiting for the official data, it appears increasingly likely that 2013 marked the start of a synchronised recovery in the advanced economies. So is it now time for the Bank of England to consider hiking the base rate? Perhaps good – and not awesome – economic growth is more appropriate to avoid a bust down the line.

Economic theory and real world experience tells us that interest rates that are kept too low for too long will distort investment decisions and lead to excessive risk-taking. They may also result in the formation of asset price bubbles that ultimately collapse. With parts of the UK housing market (including London and the south-east) posting double-digit returns in 2013, the FTSE 100 within arm’s reach of an all-time high last seen during the tech bubble (and up over 60% since 2009), and UK non-financial corporate bond spreads 45 basis points away from 2007 lows; it is clear that ultra-low interest rates have had a great effect on both financial markets and the real economy.

At the risk of being called a party pooper, here are 5 reasons why I think we could see an interest rate hike before year end (the market is pricing in around February/March 2015), and certainly before the third quarter of 2016 (the time when the BoE think the unemployment rate will fall to 7%).

  1. Asset price bubbles are forming
  2. Unemployment is falling quickly towards 7%
  3. Inflation risks should not be forgotten
  4. The Taylor rule suggests interest rates are way below neutral
  5. The risk of Euro area break-up appears to have fallen

Asset prices bubbles are forming

There has been a significant run-up in UK financial assets over the course of the past five years, particularly since QE became a feature of the financial landscape. Investors in equity and bond markets alike have been enjoying the fruits of QE. Those that own financial assets have seen their net wealth increase substantially from the post-crisis lows. Consensus forecasts for 2014 suggests that most market forecasters expect another robust year for risk assets, fuelled by easy money and the search for positive real returns.

Of course, the greatest financial asset that the average UK household own is their own house. In 2011, it was estimated that around 15 million households are owner-occupied (a rate of around 65% of total households). Thus it is unsurprising that newspaper readers are usually hit with a headline about rising house prices on a daily basis. House prices, on a number of measures, have begun to accelerate again with low interest rates and tight housing supply a key contributor to the price increase. Low interest rates have given UK consumers the incentive to accumulate high levels of household debt compared to their incomes.  The average house price is now 5.4 times earnings, the highest level since July 2010 and well above the long-run average of 4.1.

UK house prices are re-accelerating and pushing higher

The Help-To-Buy scheme is contributing to the run-up in this highly leveraged and interest-rate sensitive sector (a topic I covered back in July here). By hiking the base rate this year, the BoE would hopefully achieve a reduction in speculation and debt accumulation in the housing sector. This would not be a popular action to take – it never is – but we should all be wary about the damage a rampant housing market can have on an economy.  BoE Governor Mark Carney – as head of the Financial Policy Committee – has already moved to stop the Funding for Lending Scheme and mentioned that placing restrictions on the terms of mortgage credit may be a tool that can be used to reign in house prices.

Whether macro-prudential policy tools will work or not remains open to debate. Ultimately, central banks are trying to focus in on one element of the economy by raising interest rates or restricting credit. We do have a real-life macroeconomic example currently taking place though. On October 1, the Reserve Bank of New Zealand imposed a limit on how much banks could devote to low-deposit loans and required major banks to hold more capital to back loans. It’s very early days but for the month of November, the Real Estate Institute of New Zealand reported a 1.2% increase in New Zealand house prices and 9.6% over the year. The RBNZ and BoE might find that trying to slow the housing market using macro-prudential measures is a bit like trying to stop a car by opening the doors and hoping that wind-resistance does the rest. You really need to put your foot on the brake.

The longer the boom lasts, the greater the pain when it inevitably ends.

Unemployment is falling quickly towards 7%

The unemployment rate has fallen from 7.9 to 7.4% over the past nine months and is a key tenet of the BoE’s forward guidance. The fast decline has seen some speculation amongst economists that the BoE may lower the unemployment threshold from 7.0 to 6.5%. Of course, the 7.0% threshold that it has set it is not a trigger to hike interest rates, rather it is a point at which the BoE would consider hiking rates. However, the labour market has improved much quicker than the BoE has been expecting with the unemployment rate now sitting at the lowest rate since March 2009. We are still well above the average unemployment rate seen during the period between 2000 and 2008, but I would argue that this was an abnormal period for the UK economy. It was a NICE period – non-inflationary, constantly expanding – and is unlikely to be repeated. Arguably the UK’s natural rate of unemployment is now a percentage point or two higher than that of the noughties, suggesting less spare capacity in the UK economy than many expect. It may not be long before we start to see wage demands start to pick up, leading to rising inflationary pressures. Higher wage growth in 2014 would bode well for consumption and household net wealth given the increase in house prices and investment portfolios.

The UK unemployment rate is below the long-run average

As it is generally accepted that monetary policy operates with a lag, (the BoE estimate a lag time of around two years), and the unemployment rate itself is a lagging indicator of economic activity. If the BoE waits until the unemployment rate hits 7%, or for confirmation that economic growth is strong, then it may be too late. A slight tap on the breaks by hiking the base rate may be appropriate.

Inflation risks should not be forgotten

Ben wrote an excellent piece on the UK’s inflation outlook last month. To quote:

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.

In addition, central banks have a nasty habit of keeping monetary policy too loose for too long. It even has a name – “The [insert FOMC Chairperson Name] Put”. The easy-money policies of the FOMC in the 1970s are seen as a key contributor to the runaway inflation seen during the period.  Eventually, the FOMC reversed its own policies, hiking rates to 19% in 1981.

Of course, what central bankers really fear is that ultra-easy monetary policy and the great experiment of QE will lead to an increase in inflation. A return of inflation will only be tamed by hiking rates. Whilst the inflation rate has been moderating in the UK and is close to the Bank of England’s target at 2.1%, it follows almost 5 years of above target inflation. Whist it is not a clear and present danger, the experience of the 1970s suggests that we cannot ignore the threat that inflation poses to the UK economy, especially as rising inflationary expectations are often difficult to contain.

The Taylor rule suggests interest rates are way below neutral

The Taylor rule provides a rough benchmark of the normal reaction to economic conditions as it relates interest rates to deviations of inflation from target and the output gap. According to the Taylor rule for the UK, a base rate of 0.5% is around 2.0% below where it should be given current rates of growth and inflation.

The BoE base rate remains highly stimulatory

Negative real interest rates have done the job by stabilising the economy, but is it now time to tap the brakes? With the UK economy growing at an annualised rate of more than 3% in the second and third quarters of 2013 (above the long-term average of 2%), the UK may be operating much closer to full employment than many currently estimate. Forward looking survey indicators and economic data suggest the UK economy is growing strongly, with business confidence at a 20 year high and the UK Services PMI for December suggesting a strong broad-based upturn. Of course, the BoE would like the other components of GDP like exports and investment to contribute more to economic growth. A rising currency wouldn’t help this. But sometimes it is difficult to have your cake and eat it too, especially if you are a central banker.

The risk of Euro area breakup appears to have fallen

Now it’s time for the “Draghi Put”. Draghi’s famous “whatever it takes” speech is probably the most important speech ever given by a central banker. The speech has had a fantastic effect on assets from government bonds to European equity markets and everything in between. More importantly, as I wrote here back in July 2013, despite the problems that Europe faces – the concerning outlook, the record levels of unemployment and debt, the proposed tax on savers in Cyprus – no country has left the EMU. The EMU has in fact added new members (Slovakia in 2009, Estonia in 2011, Latvia in 2014). European countries remain open for trade, have continued to enforce EU policies and have not resorted to protectionist policies. EU banking regulation has become stronger, the financial system has stabilised, and new bank capital requirements are in place.

This bodes well for the UK, as stabilisation in the Eurozone suggests stronger export demand, increased confidence, and higher investment in the UK from European firms. Perversely, an interest rate hike might actually improve confidence in the UK economy, signalling that the central bank is confident that economic growth is self-sustaining.

The BoE must walk the tightrope between raising rates slightly now to avoid higher inflation and financial instability or risk having to do a lot more monetary policy “heavy-lifting” down the line. A base rate at 0.5% is way below a neutral level and the BoE has a long way to go before getting anywhere near this level. It could act this year and gradually start raising interest rates to lessen the continued build-up of financial imbalances. The difficult action in the short-run to raise the base rate will help to support “healthy” economic growth in the long-run.

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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.

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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.

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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.

ben_lord_100

The M&G YouGov Inflation Expectations Survey – Q3 2013

Despite high unemployment rates, excess capacity and a sanguine inflation outlook from the major central banks, it is important to keep an eye on any potential inflation surprises that may be coming down the line. For instance, we only need to look at ultra easy monetary policy; low interest rates and improving economic growth to see that the risk of an unwelcome inflation shock is higher than perhaps at any time over the past five years. The development of forward guidance measures is a clear sign that central banking has evolved substantially from 2008 in the form of Central Bank Regime Change. It appears that there is a growing consensus that inflation targeting is not the magical goal of monetary policy that many had once believed it to be and that full employment and financial stability are equally as important.  Given that monetary policy appears firmly focused on securing growth in the real economy – at perhaps the expense of inflation targets – we thought that it would be useful to gauge the short and long-term inflation expectations of consumers across the UK, Europe and Asia. The findings from our August survey, which polled over 8,000 consumers internationally, is available in our latest report here.

The results suggest consumers continue to lack confidence that inflation will decline below current levels in either the short or medium term. Despite evidence that short-term inflation expectations may be moderating in some countries, most respondents expect inflation to be higher in five years than in one year. Confidence that the European Central Bank will achieve its inflation target over the medium term remains weak, while confidence in the Bank of England has risen.

The survey found that consumers in most countries continue to expect inflation to be elevated in both one and five years’ time. In the UK, inflation is expected to be above the Bank of England’s CPI target of 2.0% on a one- and five-year ahead basis. All EMU countries surveyed expect inflation to be equal to or higher than the European Central Bank’s HICP target of 2.0% on a one- and five-year ahead basis. Long-term expectations for inflation have changed little in the three months since the last survey, with the majority of regions expecting inflation to be higher than current levels in five years. Five countries expect inflation to be 3.0% or higher in one year: Austria, Hong Kong, Italy, Singapore and the UK.

Consumers in Austria, Germany and the UK have reported an increase in one year inflation expectations compared with those of the last survey three months ago. This is of particular relevance for the UK, where the Bank of England has stated three scenarios under which the Bank would re-assess its policy of forward guidance. The first of these “knockouts” refers to a scenario where CPI inflation is, in the Bank’s view, likely to be 2.5% or higher over an 18-month to two-year horizon. Short-term inflation expectations in Singapore and Spain continued their downward trend in the latest survey results, registering their third straight quarter of lower expectations.

Inflation expectations - 12 months ahead

Over a five-year horizon, the inflation expectations of consumers in Austria, Germany, Italy, Spain and Switzerland have risen. Whilst inflation expectations in Switzerland remain at the lowest level in our survey at 2.8%, consumers have raised their expectations from 2.5% in February. Long-term inflation expectations in France and the UK remained stable at 3.0%. Meanwhile, consumers in Hong Kong and Singapore have the highest expectations, at 5.0%, although the Hong Kong number shows a decline from 5.8% three months ago.

Inflation expectations - 12 months ahead

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Full time, not part time, economic recovery

When meeting UK clients we obviously spend a lot of time discussing employment and the relative strength of the UK economy. The chart below from the Bank of England shows the recovery in employment in comparison to previous recessions. It actually looks quite good versus the other mega recessions.

UK employment is well above previous recession levels

One very good common question we often get is along the lines that the employment number is “not real” as part time employment has gone through the roof.

The chart below shows part time employment as a percentage of the total number of workers in the UK. There is obviously an ongoing trend to part time employment that has continued from the peak of the crisis. It appears that part time employment increased relatively rapidly through the recession. However, since 2010 the ratio has been declining. Therefore the recent recovery in employment appears genuine and not flattered by part time workers.

Part time employment has moved sideways since 2010

The UK economic recovery is real, and thankfully fiscal deficits, and interest rate policy have worked. The market’s fears of permanent recession are diminishing as reflected in the current bear market for UK gilts. The economic panic illustrated by very low yields where gilts became very dear (see this blog from January 2012), is over. The gilt market yield is returning towards better value, with ten year yields once again around three percent, as the UK economic recovery remains firmly on track.

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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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It’s a knockout – why the gilt and currency markets have no love for Carney’s forward guidance

Millwall FC wasn’t the only team to trek up to Nottingham yesterday from London and to come back empty handed (at the hands of the mighty, mighty Forest).  Team Carney from the Bank of England also had an unproductive time of it in the East Midlands as the new Governor gave his first speech in the role to the CBI, Chamber of Commerce and the Institute of Directors.  Since the publication of the August Inflation Report, in which the Monetary Policy Committee delivered its framework for forward guidance, the markets have done the opposite of what the Bank had hoped for.  The gilt market has sold off – not just at medium and long maturities, which are largely outside of direct Bank control and are more dependent on global bond market trends, but also at the short end, where 5-year gilt yields have risen by 20 bps in under a month.  There has also been a de facto tightening of UK monetary conditions through the currency.  Trade weighted sterling is 1% higher than it was before forward guidance came in.  Both the gilt market and the pound went the “wrong” way as Carney discussed forward guidance yesterday afternoon.  The Overnight Index Swaps market (OIS), which prices expectations of future official rate moves, fully prices a 25 bps Bank rate hike between 2 and 3 years’ time.

Slide1

So why don’t markets believe Mark Carney?  In yesterday’s speech he was clear that the UK’s economic recovery was “fledgling”, and weaker than recoveries elsewhere in the world.  He spent some time discussing how a fall in unemployment to the 7% threshold would mean 750,000 new jobs having to be created, which would take some time, possibly three years or longer.  And even if growth picked up, it didn’t necessarily follow that jobs growth would be strong.  But two things led gilts lower yesterday afternoon.  Firstly there was the announcement that UK banks would be able to reduce the amount of government bonds that they hold as a liquidity buffer so long as their capital base is over 7% risk-weighted assets – potentially triggering sales of tens of billions of gilts over the next couple of years.  But more importantly, Carney’s attempted rollback from the “knockouts” stated in the Inflation Report was not strong enough.

On page 7 of the Inflation Report, after detailing the forward guidance linking rates and asset purchases to the 7% unemployment rate, there are three “knockouts” which would cause the guidance to “cease to hold”.  The first knockout is the most important.  If CPI inflation is, in the Bank’s view, likely to be 2.5% or higher in 1 1/2 to 2 years’ time then the unemployment trigger becomes irrelevant.  The other two knockouts were that medium term inflation expectations become unanchored, and that the Financial Policy Committee judges that the monetary policy stance is a significant threat to financial stability.

So for all the talk of the UK’s weak economy, and the accommodative stance that the Bank will take to allow the unemployment rate to fall to 7%, perhaps over many years, don’t forget that if CPI inflation looks likely to be at 2.5% or higher, the MPC will ignore the jobs market promise.  Since the middle of 2005, UK CPI has been at or above 2.5% most of the time, through a strong economy and (for longer) the weak economy.  Since the start of 2010 there have only been 3 months of sub 2.5% year-on-year CPI.  And in 2008 and 2011 the year-on-year rates exceeded 5%.

Slide2

Of course, the Bank of England can forecast inflation to be whatever it likes over the next 1 1/2 to 2 years.  Its inflation forecasts have famously been awful for years, always predicting inflation would return to 2% when it always was much higher than that.  But it will be important for Carney to earn some credibility here in the UK, and the days of the Inflation Report’s “delta of blood” inflation forecast always showing a mid point for future inflation of 2% must surely have ended when Mervyn King left.  What does the outside world think about the prospects of UK inflation being below 2.5% in the future?  Here the news is better – the consensus broker economic forecast is for CPI to fall to 2.4% in 2014 and 2.1% in 2015.  And the implied inflation rate from the UK index-linked gilt market is for an average of 2.8% per year over the next five years on an RPI basis, which given the structural wedge between RPI and CPI suggests that the market’s CPI forecast is somewhere below 2.5%.  M&G has launched a new Inflation Expectations Survey, together with YouGov.  We should have August results shortly, but in our last release we saw that 1 year ahead UK consumer expectations of inflation ran at 2.7% (a fall from 3% a quarter earlier) and 5 year ahead expectations were at 3%.  Higher than the 2.5% target, but consumer expectations are often higher than the market, and the 3% level has been stable (well “anchored”).

But as we have seen, UK inflation has been notoriously sticky.  Not because consumers are demanding more goods than the shops can supply (although there has been some long awaited good news from the retail sector lately, with sales stronger), as in general real incomes have been squeezed and discretionary spending has been hit.  But because non-discretionary items, like food and energy costs, have substantially exceeded the inflation rates of consumer goods.  Add to this administered prices relating to public transport costs or university tuition fees and we can see that the UK’s “inflation problem” is potentially something that a monetary policymaker can only influence by forcing discretionary spending into deflation.  The chart below shows that so long as the non-discretionary basket of goods keeps inflating at around 5% per year, there must be virtually no inflation in discretionary goods in order to get below Carney’s 2.5% knockout.

Slide3

So it is going to be tough for the market to believe that the CPI inflation “knockout” won’t have a decent chance of coming into play well before the 7% unemployment threshold is reached.  I think Carney missed an opportunity to move away from the knockouts yesterday – he certainly didn’t use the term again, and implied that the gilt market’s move lower was driven by international developments and over-optimism about the prospects for a quick fall in UK unemployment.  But the three knockouts were almost dismissed in the sentence “provided there are no material threats to either price or financial stability” rather than given the prominence that they were in the Inflation Report.  But it looks as if the gilt and currency markets need something stronger if they are to produce the monetary easing that, from Carney’s bearish analysis of the UK economy, it still needs.

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