The five year break-even inflation rate has fallen to below 2.5 per cent, its lowest level since early 2013. Because this is based upon RPI inflation which is currently a percentage point higher than CPI inflation, it implies that investors expect CPI inflation to average less than 2 per cent over the next five years.
This fall is a response to the 40 per cent fall in oil prices since August and to the latest figures which showed that inflation fell to just 1 per cent in November, its lowest rate since September 2002. Economists expect inflation to fall even lower. Victoria Clarke at Investec says it could go below 1 per cent "for several months". And Martin Beck at the EY Item club says there's "a realistic chance that annual inflation could turn negative".
Markets expect the Bank of England to respond to this by keeping interest rates down for a long time. Futures markets don't expect the Bank rate to rise until the third quarter of 2015, and are pricing in only a 0.3 percentage point rise in three month interbank rates by December 2015. "The Bank has plenty of room to leave policy ultra-loose," says James Knightley at ING.
But there is one reason why it might not do so. Latest figures show that wage inflation is rising; average earnings rose by 1.4 per cent in the year to the three months ending in October whereas they had fallen in the year to June. This will corroborate the concerns of Martin Weale and Ian McCafferty - the two MPC members who voted to raise rates at the last meeting - that "wage growth might pick up sharply". Worryingly, higher wages don't seem to be offset by productivity gains. Total hours worked rose by 0.7 per cent in the three months ending in October, the same rate as GDP grew - which implies no rise in productivity.
Economists say the Bank will pay close attention to wage growth in the new year. The question is: will low inflation lead to low expected inflation and hence lower pay settlements or will a tighter labour market raise pay growth? Some fear the latter, which would trigger a reassessment of the gilt market's interest rate expectations. Standard Life's James McCann says: "the Bank will tighten earlier than the markets expect".
