Markets cast doubt on UK’s inflation goals
If financial market gauges are to be believed, Britain will struggle to keep inflation in check for the next half century. Those signals are likely distorted by other factors, but they are contributing to questions over the Bank of England’s ability to contain inflation as Britain prepares for an era of economic uncertainty outside of the European Union. Having watched sterling crash to a 31-year low against the US dollar on Brexit fears, the BoE will likely next week jack up its inflation forecast to show a bigger overshoot of its price target than any time since it gained independence in 1997.
In its August forecasts, the BoE already predicted inflation of 2.4 percent in two and three years’ time, above its 2 percent target. Since then, sterling has fallen further on worries that Britain will take a hardline approach to the Brexit talks. For Britain’s monetary guardians, dealing with rising inflation could be difficult. Its ultra-easy approach has been criticized by some lawmakers while tightening conditions could risk choking off economic prospects altogether.
Economists are keeping a fairly cool head on near-term price prospects for now, and no one is expecting a return to the double digit inflation of the 1970s and 1980s. Like central bankers, they tend to look through blips caused by factors such as currency depreciation. But long-term worries are creating some concerns among investors. “The long-term inflation forecasts are high and that then increases the urgency of having to protect yourself against inflation, so it can become a vicious circle,” said John Walbaum, head of investment at consultancy Hymans Robertson.
Over the past decade, inflation has overshot the BoE’s target eight times, and by more than 0.5 percent on five occasions, according to the Office for National Statistics. Several economists with leading international banks have said they expect prices to peak around 3 percent at the end of 2017, lower than 5 percent seen after the financial crisis and bouts of more than 15 percent seen in the 1970s and 1980s.
For longer-term forecasts, market pricing is seen as one of the only signals, specifically breakeven rates on inflation-linked bonds. Breakeven rates the difference between real yields on inflationlinked bonds and nominal bond yields - indicate the average rate of inflation needed for an inflation-linked bond to be a better investment than the regular bond.
Inflation-linked bonds are indexed to retail prices, which economists say is roughly around 1 percent higher than consumer prices, implying that a breakeven rate of around 3 percent suggests the BoE is hitting its target. Fifty-year breakeven rates are currently around 3.5 percent. Some economists say the fall in the currency since the Brexit vote is likely to blame, raising the risk that average inflation rates could stay elevated for many years. “The market is pricing in a short-term overshoot in inflation and that may be reflected all across the curve, even at maturities that you may not expect,” said Sam Hill, senior UK economist at RBC Capital Markets.