UK inflation: the Bank of England would have to generate significant disinflation in the majority of goods we consume to hit the 2% inflation target, killing any recovery. Food and administered price rises are the problems.

With the UK’s 2% CPI inflation target having now been exceeded for 39 consecutive months, last week’s budget formally acknowledged the on-going situation and changed the Bank of England’s remit.

Although chancellor George Osborne maintains that medium-term price stability represents “an essential pre-requisite for economic prosperity”, the updated remit simultaneously introduces the concept of flexible inflation targeting in the short term, asserting that the Bank of England committee “may wish to allow inflation to deviate from the target temporarily” in exceptional circumstances, i.e. as the result of shocks and other disturbances. In short, inflation targeting looks like it will continue to take a back-seat to the pursuit of growth and employment with the chancellor accepting that inflation is likely to rise further and may remain above the 2% target for the next two years. It is also interesting to note that there is no restriction on how far inflation is permitted to deviate from its target, nor has any time limit been set for any such deviations.

Allowing more flexibility simply reflects the reality, and it can therefore be argued that this is probably based on the theory that whilst current inflation rates are hurting consumers, hiking rates to bring inflation down – by raising mortgage and loan rates – would hurt even more. Wage growth is only just above 1% per year, so the authorities perhaps feel that overshooting the inflation target is unlikely to create an inflationary spiral based on rocketing pay settlements.

Citigroup’s Michael Saunders has presented an interesting piece of research which he believes breaks down the root causes of inflation stickiness. The research shows that for most of the inflation basket, there isn’t a problem and for the 27% where there is a problem, it is not clear that hiking rates would be a solution.

Causes of inflation stickiness


The first graph demonstrates the inflation generated from demand-insensitive areas (e.g. goods that have relatively static demand curves, regardless of changes in the price) such as utilities, education, tobacco, food and alcoholic beverages. This part of the basket contributes to 27% of the overall CPI figure. In recent years, this proportion has persistently exceeded the Bank of England’s 2% target thanks to formulae on these prices which allow “inflation plus” rises, and in the case of food, volatile weather. The Bank of England explains this away by treating it as a one off shock; Michael Saunders argues that this portion of the CPI basket is seeing a consistent series of small shocks, and is therefore predictable.  Therefore in order to compensate for the above-target growth in price level of these prices, the inflation rate of the remaining portion of the basket of goods would have to see much lower inflation to offset this and to meet the 2% target. The required adjustment is demonstrated by the green line in the second graph, while the actual inflation rate for this portion of the CPI basket is shown in yellow.

As you can see, Citigroup’s research shows that the actual inflation rate for the remaining portion of the CPI basket of goods must fall considerably ( from around 2% per year to around 0.7% per year) if the formal 2% inflation target is to be met. Indeed, in the aforementioned Bank of England remit, George Osborne himself concedes that the impact from both regulated and administered prices have together contributed to the persistent inflationary environment.

It is subsequently made clear that in the current environment of deliberately loose monetary policy and the ensuing departure from the inflation target, UK above-target inflation is baked into the cake unless the Bank of England tries to depress demand for the remaining demand-sensitive proportion of the basket. If this inflation overshoot is not curbed over time, this could potentially affect expectations of future inflation, calling the Bank of England’s ability to deliver medium term price stability into question. Therefore, despite champagne being removed from the CPI’s 2013 basket of goods, let’s hope that over time the Bank of England’s credibility is still something the UK can celebrate.

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Judgement Day – RPI Damp Squib

Today has seen the release of the decision by the National Statistician about what to do with the Retail Prices Index. We were told of the consultation in September last year, and were presented with 4 options, ranging from 1) to do nothing, to 4) to make RPI as much like CPI as possible.

Our view was always that the consultation arose as a result of the desire to correct an error made in the clothing component of RPI in January 2010 see blog. This change had seen the ‘wedge’ between RPI and CPI anomalously and erroneously increase by close to 1% following its implementation. We therefore believed that it was perfectly appropriate for the National Statistician to correct this error, and so we were expecting to see Option 2 materialise, which most closely targeted correcting this source of the wedge.

UK linkers had noticeably underperformed other markets since the announcement of the consultation. The market had initially started to price in a 30 to 50 basis point reduction in the wedge of RPI over CPI in expectation of Option 2′s intention to rectify the error.  However, as Judgement Day approached nervousness increased in the linker market as people started to worry that the more severe options could be implemented.

Were Option 4 to have been recommended today, the wedge of RPI over CPI would have been reduced by approximately 100 basis points. This would have been a severe and brutal change for the index linked bond market. All else remaining equal, this change would have seen breakevens on index-linked bonds fall by approximately 70 basis points (allowing for 30 basis points of underperformance already priced in).  To put it another way, this would have see the price of the longest index-linked gilt, the UKTi 0.375% 2062s, fall from 107.7 to about 85, a fall of 21%. Today, things really could have got nasty!

But the decision today has been Option 1. No change. Whilst highlighting that “the RPI does not meet international standards” and recommending that a new index be published, Jil Matheson “also noted that there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations”. For the release, go to this link.

All the lobbying that we – and some others – have been doing behind the scenes has been worth it. In the Financial Times today, Chris Giles (who was on the Consumer Prices Advisory Committee) stated that the ONS rejected the committee’s advice in the face of  ‘overwhelming opposition to changes in the calculation of the RPI’.  The market has recently opened, and is removing the expected reduction of 30 basis points or so from Option 2. Breakeven inflation rates at the moment are up by 37 basis points at the 10 year part of the curve and by 22 basis points at the long end. The 2062 index-linked gilt is up by 12 points in price terms, and the whole linker market is rallying in the relief that no change is being made…

…for now! We will soon see the creation of a new RPI index, called RPIJ. This effectively makes RPI equal to CPI through making the older RPI index more modern by removing arithmetic mean and replacing it with geometric mean. This will be run in parallel with the old, untouched index. But it suggests that this debate is not over forever. We could again see recommendations to move from RPI to RPIJ, but more likely, we will soon start to debate moving the index-linked corporate bond market from RPI linkage to CPI linkage.  The creation of RPIJ does seem a little irrelevant, where a new index has been created that few people will care about given that inflation linked bonds will continue to be linked to RPI and the government is clearly dedicated to linking other forms of government compensation to CPI.

Ultimately, though, even if we had seen a brutal reduction in RPI today, I still think that the strong case could be made to want to own UK index-linked bonds over the medium and long term. And changing the calculation to option 4 could have saved the Treasury a whopping £3bn per year, so while the decision to make no change has been great for inflation linked bond holders, it’s not so great for the UK’s coffers.   Finally, the strong opposition to the RPI changes gives you a good idea of how hard it will be to implement austerity measures, and if we aren’t going to get out of this debt crisis through austerity, then the likelihood of us getting out of it with the help of inflation has just increased a bit!


Markets start to think about inflation again

Over the last few weeks we have witnessed a meaningful bounce in inflation breakevens in the UK, Europe and the US. When breakevens are rising, it is a signal that the fixed income market is anticipating higher inflation than has been priced in. It also means that index linked bonds are outperforming conventional bonds. In the UK, the linker gilt of 2016 has outperformed the conventional gilt by 45 to 50 basis points in yield terms since the start of this year.

Inflation expectations are rising

Why have the bond markets started to price in higher levels of inflation?

Perhaps there is an element of geo-political risk affecting the oil price, which feeds into the inflation baskets in a plethora of forms? Yes, but I don’t think oil is the major culprit here, although in the US, where oil is taxed far less than in the UK or Europe, inflation is far more sensitive to changes in the oil price. See Jim’s blog here.

Perhaps rising breakevens owe to fears around money creation? In Europe, at the end of 2011 the interbank market was completely disfunctional, and we were entering a deflationary spiral. But the long term repurchase operations (LTRO) have added somewhere in the region of €1 trillion euros to banks over the last few months, the interbank market has been showing signs of being slightly less disfunctional, and the risks of deflation feel for the moment substantially reduced. In the UK, the mechanism of quantitative easing boosted the prices of conventional gilts more than index linked gilts, as the Bank of England did not purchase linkers directly. This artificially suppressed the relationship between the conventional gilt and the linker (the breakeven), at exactly the moment when money creation ought, in my opinion, to have seen higher inflation risk premia priced in. The strong performance of index linked gilts in the UK either owes to a fear that improved economic data means we are closer to the end of QE than the beginning, so the artificial source of demand for gilts is not going to be in the market for much longer (a relative call), or owes to the market’s deciding that we are not going into a disinflationary or deflationary economy, and are more likely to see on target inflation or higher.

It is worth thinking about the levels of 5 year breakevens in the chart, a relative valuation measure. In the UK the bond market is expecting inflation to average 2.8% a year for the next five years. Remember though that this is RPI inflation, which historically has averaged 0.8% more than CPI. If we assume this historical relationship holds, then this 5 year breakeven implies CPI will be bang on the Bank’s target of 2%. So on this basis the breakeven does not make inflation protection look expensive at all. Considering the 5 year breakeven in Europe, which is currently 1.6%, this is still pricing in inflation being below the 1.8% (ish) target on average for the next 5 years. With aggressive money creation (at last!), surely the risks are skewed to the upside? In fact, only the US market is pricing in inflation to be above target for the next 5 years. I think that this is the correct side of the inflation target for linkers to be valued at, and I believe there is a good chance the UK and European markets start to move towards this US dynamic.

Why? Firstly because of the ultra low interest rates and ultra accommodative monetary stance at the ECB, BoE and Fed. And also because of the large scale money creation we have seen in all three markets and have discussed briefly above. But most importantly to me is the fact that at this moment in time, the three central banks in question all have a clear and visible inflationary bias. They would rather have inflation than deflation (rightly). But now they are showing a propensity to favour above-target inflation over below-target inflation. This is tantamount to a (temporary or permanent, we do not yet know) change in the inflation targets. And this must, in my opinion, see higher inflation risk premia. How do we show this clear inflationary bias? Inflation is significantly above target in all three economies, and yet policy is not only not being tightened, the taps are still very much on!


UK inflation shocking?

UK CPI inflation jumped from 4.0% to 4.5%, versus expectations of only a slight increase to 4.1%.  Core CPI, which strips out food and energy prices, soared from 3.2% to 3.7% and is now at easily a record high (data goes back to 1997).  One bank called the inflation numbers shocking, arguing other economies aren’t seeing anything like this surge in core inflation, UK monetary policy is too loose and the MPC should hike rates in August.

The first thing to point out, as previously discussed on this blog (see here), is that the CPI figures include the VAT increase to 20% in January.  The VAT increase is presumably temporary unless there’s another hike next year, and will therefore fall out of the inflation numbers early next year (it’s difficult to say exactly when as it depends on the timing and extent of the VAT passthrough from retailers to consumers).  This chart gives a truer ‘long term’ picture of UK inflation by stripping out this tax effect, and as you can see, 2.8% is still within the Bank of England’s target (albeit energy and food price increases over the past year have pulled it uncomfortably close to 3%).  Note that the headline CPI number came in temporarily lower than the constant tax measure through 2009 following the VAT cut in January of that year, but the last two years have seen the headline CPI inflation number look temporarily high.

The second thing to point out is that even if inflation does continue rising through this year (and maybe unexpectedly fails to fall next year), will the Bank of England really hike rates?  Well the market seems to think so, as it’s still pricing in two 0.25% rate hikes in the UK by this time next year, with the first hike coming in November.

However this chart shows just how badly wrong the market has got its UK interest rate forecasts.  Each dotted line shows the market’s expectations of the future course of the Bank of England base rate at the time of each quarterly inflation report going back to August 2009.  In August 2009, the market was pricing in a Bank of England Bank Rate for May 2011 of 3.25%.  Instead, the Bank Rate has remained firmly stuck at 0.5%.  It’s all the more surprising if you consider that UK inflation has consistently exceeded market expectations at the time of release, so if inflation is the primary driver of the Bank Rate, you’d have expected to see the market underestimate the Bank Rate over this period.

Why has the market been so wrong?  The answer is all about growth – investors have placed too much emphasis on inflation in their Bank Rate forecasts.  The UK economy is no bigger than it was six months ago.  UK consumption has flatlined. With such a vulnerable consumer, housing market, and banking sector, we can’t risk higher rates.  With that in mind, it’s not a bad idea to have a fresh look at the second part of the opening paragraph in the Bank of England’s quarterly Inflation Report;

‘In order to maintain price stability, the Government has set the Bank’s Monetary Policy Committee (MPC) a target for the annual inflation rate of the Consumer Prices Index of 2%.Subject to that, the MPC is also required to support the Government’s objective of maintaining high and stable growth and employment.’


Why the UK has a real rate problem

The financial crisis is resulting in the authorities, the public, and investment managers seeing things they did not expect to see. Today’s headline RPI level of 5.5% is a record 5% above the Bank of England base rate of 0.5%, resulting in a negative real interest rate (base rate – RPI) of -5%. This is the most divergent I’ve seen this in my 25 years in the city (see chart).


The bond bears think that the relationship will be normalised by a rapid increase in the base rate and a fall in inflation towards more normal levels. The bulls would suggest that the inflation measure reflects temporary factors and will therefore decline to more normal levels with only modest rate increases by the Bank of England.

However, the fate of the base rate and inflation does not sit with the bond bulls and bears but with the Bank of England Monetary Policy Committee (MPC). Their policy of ultra low rates means the MPC is missing their CPI based inflation target of 2% on a regular monthly basis. Since September 2007, inflation has been above 2% in 35 out of 42 months.

Why are they doing this? Presumably the MPC believes that the high inflation rate will be temporary in nature, however there could be other motives behind their policy stance. The Bank of England via QE has previously determined that interest rates had reached their effective bounds in stimulating the economy, as a central bank cannot achieve negative nominal rates. Therefore in order for their rate setting policy to work they have become very relaxed with negative real short term interest rates as they pursue a policy of cleansing the system of its financial hangover from the credit bubble as best it can.

Lets hope from  the Bank of  England’s point of view that the hair of the dog cure of ultra low real rates is actually an appropriate diagnosis of  a fragile, staggering UK economy. Otherwise we could all end up in a dizzy inflation spiral.


Hike Rates to Stamp out UK inflation. Really?

This week RPI broke through 5% and CPI broke through 4%. The media are almost universally calling for rate hikes, politicians are starting to voice their opinions loudly, and many investors are worried.

If the market reacts to higher inflation by pricing in more rate hikes, that’s bad news for gilts and index-linked gilts.  But for investors such as us who are trading so-called breakeven strategies (ie taking a view on changes on the future inflation rate that’s implied by the bond market), a key question is do conventional gilts or index-linked gilts perform better as the Bank starts hiking? If the market believes the rate hikes will solve the inflation problem then the breakeven inflation rate would be expected to fall and linkers would perform worse than conventional government bonds. If the market believes that a rate hike won’t have any effect, or ascribes low credibility to the policy and its makers, then you’d expect linkers to outperform as the market prices in higher inflation in future.

There is an interesting and frequently overlooked short term dynamic between inflation and interest rates. Mortgage interest payments (MIPs) are a part of the Retail Price Index (RPI) number. MIPs aren’t part of the Consumer Price Index (CPI), the measure of inflation  the Bank of England target, although bond markets are (currently) priced off RPI, so that means MIPs matters. 

MIPs represent 3.4% of the RPI basket today. So Jim emailed us from the ski slopes saying we should find out what proportion of borrowers are on SVR and trackers, make some assumptions about a plethora of things, and try to estimate what proportion of a rate hike would feed directly into higher MIPs and so into RPI.

What we ended up doing instead, somewhat indolently, was calling BarCap’s inflation guru, Alan James, and asking him what his estimate of the sensitivity of RPI to a rate hike is? Alan was (and is) a great help to us in our preparation for the inflation funds, and I should take this opportunity to thank him! Unsurprisingly, to those who have seen Alan present or who have met him, he had already done this work, and he informed us that his belief is that the relationship is about 0.66, meaning that two-thirds of a rate hike will directly pass through to RPI via MIPs.

The market is now pricing in three 25 basis point rate hikes this year.  That means of 75 bps of hikes, MIPs will be pushed up enough to cause RPI to rise by about 0.5%. So the Bank of England hikes rates to lower inflation, and a direct offshoot of this is that RPI actually rises!  As this MIPs increase feeds through to RPI, I’d expect to see the front end of the linker curve outperform conventional gilts.  It’s not unreasonable to expect breakeven expectations to fall at the longer end reflecting the belief that the dawn of a monetary policy tightening cycle will mean we’ll be moving towards a structurally lower inflation environment. Interesting, these unintended consequences…


Emerging market inflation – a big risk to global growth

The reasons behind the ugly scenes in Tunisia are down to a combination of political and economic factors, but at least part of the discontent stems from rising food and energy prices.  Public unrest in Tunisia has spread to Jordan, where thousands were protesting against the government over the weekend, and demonstrations are also spreading to Egypt (10 year US$ bonds are down 4% today, and the 30 years US$ bonds down as much as 8%). 

The problem these countries face is that food and energy prices are a much bigger percentage of an emerging consumer’s shopping basket than for a developed consumer’s basket.  Food and energy therefore carry a much higher weight in domestic consumer price indices within emerging markets, which is something I discussed last year when going over some of the risks to the emerging market story (see here). 

As this chart demonstrates, there’s a reasonable correlation between a country’s wealth (as measured by GDP per capita) and the weighting of food and energy in the country’s CPI basket.  Poorer countries therefore tend to be those that are most vulnerable to rising commodity prices, so of the major emerging markets I’ve looked at, food and energy constitutes over 60% of the Philippines’ consumer basket, while South Korea, Taiwan and Israel’s inflation indices have a far lower exposure.  (Note that the latter countries should probably be considered ‘emerged’ rather than ‘emerging’ – Taiwan in fact had a higher GDP per capita than France and Japan last year).

While GDP per capita is a good indicator of the degree that a country’s inflation rate is vulnerable to rising food and energy prices, some emerging market countries would likely welcome higher prices if they’re producers of the stuff.  This chart from Nomura plots the weighting of the food and energy component in the CPI basket for a range of emerging market countries versus the degree to which the country is an importer or exporter of food and energy, where countries to the right are net importers and countries to the left net exporters.  The country that would most likely welcome higher commodity prices is unsurprisingly Russia, while the country that is most exposed is, again, the Philippines, which happens to be the world’s biggest rice importer.  
The global growth drivers India and China also flash up as being vulnerable to rising food and energy prices.  In India, the inflation rate was 8.4% year on year in December, driven by food prices climbing at 16.9% and today governor Duvvuri Subbarao warned about surging inflation, suggesting further interest rate hikes.  China’s official inflation rate is 5.1% year on year, and has only been higher in the last decade from mid 2007 to mid 2008.  I wouldn’t be surprised if China’s unofficial inflation rate was higher still, and the authorities have responded by tightening monetary policy and allowing a degree of currency appreciation, both of which should result in weaker Chinese growth. 

To an extent, higher food and energy prices are a result of expansionary economic policy in the US combined with a reluctance of emerging market countries (particularly China) to allow their currencies to appreciate versus the US dollar.  Would it not be ironic if the very policies that US authorities have pursued to return the US economy to growth then proceed to be the cause of global economic weakness?


It’s not 1993-1994 in the government bond markets. Unemployment is still way too high to provoke a Fed hike. But the Bank of England might be on the brink of a policy error…

US Treasury Bond Market in ‘93 -‘94Government bonds have been selling off over the past month. Since mid October the 10 year gilt yield has risen from 2.85% to 3.63%, the 10 year bund from 2.25% to 3.00%, and the 10 year US Treasury from 2.40% to 3.40%.  The damage has been even greater in peripheral Europe – Spanish 10 year yields are up by nearly 150 bps over that same period.  Part of this reflects the return to a “risk on” world, where equity valuations looked compelling as the economic data came in generally stronger than expected, leading to less demand for safe haven assets – especially as those safe haven assets were trading around record low yields.  The other important part of the move is about a rise in inflation expectations. This had already started in mid 2010, as commodity price inflation (for example cotton, coffee, energy) had taken off, but the move was exacerbated by the US Fed’s announcement of QE2 in early November.  5 year inflation expectations as derived from TIPS yields have risen from a low of 1.13% at the end of August to 1.95% now.  Add to this fears about sovereign creditworthiness (others have now joined us in worrying about the US’s AAA credit rating, and Europe faces its own default crisis) and it is no wonder that bond yields have risen.  Might this be a re-run of 1993/1994, when government bonds rallied hard in 1993 before the Fed unexpectedly hiked rates in February 1994, provoking a 200 bps sell off in 10 year Treasury yields?

I went back to look at the economic environment at the time, to see how different it was to today.  The thing that surprised me was that inflation had been steadily falling throughout 1993, both on a core and a headline measure. It didn’t start to pick up until the second quarter of 1994, after the Fed had hiked. 

The inflation picture is similar now – the starting point is lower, but actual inflation had been coming down throughout 2010, towards record lows on the core measure.  So when the Fed hiked in 1994 they were doing so in a falling inflation environment.  What is different is the employment situation.  In 1993 the unemployment rate was falling decisively, and was at a much lower level than it is today – i.e. the unemployment rate was falling towards 6.5%, with some estimates of full employment at just under 6%.  The US currently has an unemployment rate of over 9%, and whilst it may have come off its peak, it is miles away from full employment.  In fact some would argue that the unemployment rate is understated at this point thanks to a significant fall in the labour force participation rate, as discouraged workers stop looking for jobs, the young go back into education, and people retire early.  Over the past couple of years the participation rate has fallen from 66% to 64.3%, compared with over 66% in `93/`94.

We think the Fed is still massively more worried about the jobs situation than it is about generating inflation.  We’ve been following the chart on the left for years – it shows that the Fed’s reaction function means that they wait for unemployment to start falling on a sustained basis before they start to hike.  In the last two cycles the lag was a year to twenty months from when the unemployment rate started to fall.  You could argue that US unemployment did start to fall towards the end of Q1 last year, which means that the Fed might hike later this year.  But in our view the level of unemployment is still way too high, and the fall in the participation rate is too severe.  In any case, in the US you can rule out an early 2011 rate hike.

Is that also true in the UK?  Unemployment here is sticky too, just below 8% on the ILO measure.  And the public sector job cuts are yet to bite.  But inflation is very sticky here and the Bank of England has missed its 2% CPI target and been at or above 3% for all of 2010.  RPI inflation is at 4.7%!  The 2.5% VAT hike will start feeding into retail prices from this month onwards, and utility and petrol prices are rising sharply.  The money markets are already pricing in two 0.25% rate hikes in the UK this year, with a small chance that there will be a third rate hike by year end.

Rate hikes would kill core inflation (although remember that mortgage rates are a component of RPI, so that measure of inflation would likely rise with every rate hike) – but they would also be GDP-suicide in this fragile economy, bringing deflation risks back into play. Hopefully the Bank still feels it can target future inflation, and has the confidence to ignore those reacting to current inflation newsflow and calling for imminent rate hikes.  But I don’t think that the Bank of England has much breathing room left, and with persistently high current inflation the Bank’s credibility is under attack.  I think we’re only one surprisingly robust inflation print away from a UK rate hike.  Let the policy errors begin…


UK linkers becoming stinkers

In the recent emergency UK budget it was announced that public sector indexation would change from RPI to CPI from April 2011.  Now, the government is proposing moving private sector schemes and the Pension Protection Fund (PPF) indexation to CPI too.  As Pensions Minister Steve Webb argued, it makes sense switching to CPI as it’s the measure that the BoE targets and (slightly more dubiously) CPI is a more appropriate measure of pension recipients’ inflation experiences.

RPI has historically been higher than CPI, exceeding CPI by 0.55% on average over the last twenty years, so if the differential between the measures continues in future then this proposed change would reduce pension fund deficits but would penalise scheme members if (and presumably when) it is implemented. 

The problem with this proposal is that you can’t buy CPI linked assets in the UK – they don’t exist.  While the correlation between RPI and CPI is reasonably close as you’d expect, the difference was as high as 3.1% in 1989 and is currently a relatively large 1.7%.  RPI linked assets are still a better hedge against inflation than any other asset class, but there will definitely need to be CPI linked assets at some stage. 

It may be possible to restructure the existing RPI linked index-linked gilts, but the easiest thing would be to issue new CPI linked index-linked gilts.  This would make the RPI linked assets currently in existence pretty redundant.  The good news is that this change, assuming it happens, will likely take years rather than months to implement and even then could well be gradual.  Furthermore, in the meantime investors have no choice other than to continue buying RPI linked assets to hedge against inflation. 

But it’s clearly a negative for inflation linked gilts overall, and we’re seeing that in terms of price action today.   Longer dated index-linked gilts are getting hit hardest, partly because they’re longer duration so are more sensitive to changes in yields, and partly because the biggest buyers of long linkers are the pension funds.  At the time of writing, UKTI 1.125% 2037s are down over 2% so far today, while the UKTI 0.5% 2050s are down 3.5%. 

Linkers maturing in 20 years or longer have now been in a bear market year to date, which is quite incredible given that long dated conventional gilts (ie those maturing in 15 years or longer) have returned over 13% over the period.   The significant underperformance of linkers has come about despite the UK inflation rate rising significantly this year, with the year on year rate of CPI climbing from 2.9% in December to 3.4% in May – as mentioned in October here, changes in the real yield is a much more important driver of returns for longer dated index-linked gilts than changes in short term inflation.


Dear George…

Mervyn King introduced himself to George Osborne last night by writing him a letter, not to wish him luck in his new and frankly unenviable role, nor to advise him on just how much austerity is needed on 22nd June to keep the markets supportive of gilts, but instead to explain why he has again overseen a rate of inflation of more than 1% above the target rate of 2%. The letter states that the Governor should:

1. Explain why inflation has moved significantly away from the target.
2. State the period within which the Governor anticipates inflation to return to target.
3. State the policy action that is being taken to deal with it.

1. The CPI index rose to 3.7% year over year in April, up from a 3.4% rise in consumer prices the previous month, and not insignificantly 0.2% above the market’s expectations for where today’s number would be. The Governor blames oil prices, the VAT increase and the fall in sterling for the inflation miss (no mention of higher duty on cigarettes and alchohol!). He believes these three factors are temporarily boosting the inflation rate and expects that inflation will fall back over time to its desired level of 2% due to the output gap. We are sympathetic with the Bank’s argument that there is a significant amount of spare capacity in the economy at present and that this will likely see inflation fall in the future.

2. Mervyn King believes that it is likely that inflation will fall back to target “absent further price level surprises…..within a year”. What a nice performance target for the year, if you are an inflation forecaster (which, thankfully, Mervyn is not): he will hit his forecast unless he is wrong.

3. The Bank of England took unprecendented action in response to the huge contraction in demand at the onset of the financial crisis with the aim of keeping inflation near target in the medium term, by which I am referring to quantitative easing and near zero interest rates. The Governor today states that in this meeting the Committee felt it appropriate to maintain the current level of stimulus in the economy, citing an appropriate balance between downside risks (spare capacity) and upside risks (commodity prices, amongst others) to inflation.

So Mervyn’s seventh letter (now to his third different chancellor) once again explains that whilst inflation is substantially higher than where he and the MPC expected it to be at this time, and whilst inflation continues to come in higher than the market’s expectations, he and the Committee are happy for the extraordinary level of stimulus to remain in the economy for now, for fear of the fall-out that would result were stimulus to be removed too soon. This is a view we here have huge sympathy with. One only has to look at the panic in the Eurozone in recent weaks to realise that the current recovery is extremely fragile. On top of this, our new government has already announced an emergency budget for 22nd June, which will surely see fiscal tightening dampening some of the inflationary effects of monetary stimulus currently in the system.

So whilst there is sure to be some heavy criticism coming from the media and other commentators about the apparant ineptitude of the MPC to correctly forecast near term inflation, spare a thought for Mervyn. First of all, whilst the MPC has got near term inflation wrong (underestimating) for the best part of the last year, its remit is to manage medium term inflation, for which it has a strong record since its independence. My interpretation of the Governor’s citing the fragile balance between ‘upside’ and ‘downside’ risks to inflation is that it is actually a balancing of near term and medium term inflation, with the former on the one hand being boosted by extraordinary policy measures and the resulting global recovery, and the latter being justified by concerns about the recovery’s persistence and strength. Perhaps he realised that the MPC was too focused on short term inflation rather than medium term inflation when it left rates too low after the crash and then had them too high from 2007 as we approached the financial crash? This is a criticism that is surely all the more cogent when directed at the ECB?

Most importantly, though, give him credit for what he has achieved. Faced with collapsing global demand, a financial system in disarray, and a freezing and contraction in the velocity and quantity of money in the economy, extreme monetary and fiscal stimulus were a necessity. The fiscal stimulus and growth of the state that resulted from the crash has meant the UK’s and most of the western world’s levels of indebtedness have risen hugely too. And the very worst case scenario in a highly leveraged world is a deflationary spiral where prices for everything are falling whilst debts still have to be repaid in full. The lesser of two evils in this case is definitely some controlled or temporary inflation to reduce the real cost of a large debt burden (not to mention that the avoidance of deflation also enables monetary policy to maintain its efficacy). And on these terms, with positive growth, positive inflation, and a recovering housing market, perhaps it is time to praise, not criticise, the MPC for its decision to embark on quantitative easing? The range of decisions we face today as an economy are inestimably preferable to the ones we could have been facing now had we seen monetary policy inaction during the crisis. Well done Mervyn, inflation above a short-term target is a result.

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