The inflation expectations puzzle

There's a curious feature of our recession that hasn't had the attention it deserves – it has not much reduced inflation expectations. The breakeven inflation rate – the gap between conventional and index-linked gilt yields – is now 2.7 percentage points for ten year maturities. Even allowing for the gap between the RPI and CPI inflation rates and an inflation risk premium – the fact that index-linked yields are low because of the danger of unexpected inflation as well as because of anticipated inflation – this implies that the gilt market does not expect the two per cent inflation target to be significantly undershot.

Yes, the breakeven inflation rate is lower than it was last spring, when it was over 3.3 percentage points. But the fact is that it has stayed high even in the face of serious worries about the economy.

In this sense, things are very different from 2008-09. Back then, inflation expectations slumped, to under two per cent, as investors feared that the recession could lead to deflation. Today, despite the very real risk that the break-up of the euro area might trigger another deep recession, they do not have such fears (or hopes!).

This poses the question: why are inflation expectations so high? To put it another way, why are investors willing to lose money – that is, accept negative real returns – to buy protection against inflation? I suspect there are two reasons.

One is that the possibility that weak demand will drive down inflation is not the only story. Whilst aggregate demand factors do look disinflationary, aggregate supply ones are more inflationary. Not only have commodity prices (so far) stayed high – Brent crude is twice the levels it hit in 2008-09 – but also productivity growth has disappeared.

Secondly, the gilt market believes that the Bank of England has both the will and the means to raise inflation. If the Bank prints enough money, then inflation will rise – though “enough” might mean a very great deal indeed. One lesson of 2008-09 is that quantitative easing works, at least to some degree. The Bank might do what it has done recently, and allow commodity price rises to raise inflation. Or – if things get really bad – the Chancellor might either raise the inflation target or switch to a nominal GDP target. Either way, there is inflation risk from policy.

All this is bad news for savers. It means that informed opinion expects inflation to continue to erode the value of our savings.

But it should also worry anyone hoping for a quick macroeconomic fix for our troubles. There are increasing calls for the inflation target to be replaced by a target for money GDP growth. One motive for this is that such a switch would raise inflation expectations, which in turn would boost spending now. This is partly because savers, anticipating more negative real interest rates, would raise their spending; partly because the hope that debt will be eroded by inflation will encourage more borrowing; and partly because everyone would want to buy now in anticipation of rising prices.

It all sounds very reasonable. However, the fact that inflation expectations have been quite high for some time, without having large stimulative effects, should warn us that expectations can be a weak lever for macroeconomic policy. And this in turn suggests we might be stuck with weak growth for some time.

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