Sometimes what doesn’t happen can be as noteworthy as what does. So it is with the gilt market’s inflation expectations.
The curious incident here is that – apart from a sell-off in longer-dated index-linked gilts triggered by fears of a change in the way retail price index inflation (RPI) is calculated – these expectations haven’t changed much recently. Although yields on five-year conventional gilts have fallen from 0.7 to 0.3 per cent since March, the five-year break-even inflation rate has actually risen slightly in this time, from 3.3 to 3.5 per cent. Index-linked yields have fallen slightly more than nominal yields, so break-even inflation has edged up.
This is weird. To the extent that nominal yields have fallen because of increased fears of recession, we’d expect break-even inflation to fall simply because recessions reduce inflation. And in fact this has been the case in the US. There, five-year break-even inflation has fallen to almost a three-year low.
So, why hasn’t the UK followed the US? One reason is sterling. It has fallen 5 per cent on its trade-weighted index since March and would probably fall more if the UK left the EU without a deal. This will raise imported inflation, and nobody expects the Bank of England to offset this by raising rates until the fog of Brexit lifts.
In this sense, sterling is doing exactly what freely floating currencies are supposed to. It is acting as a shock absorber, helping to insulate the stock market from the local economic shock that is Brexit.
This helps explain the pattern in my chart below, which shows a correlation between break-even inflation and the All-Share index. Rises in break-even inflation in 2006, 2010 and 2017 all saw rises in share prices too, while falls in break-even inflation in 2008, 2012 and 2016 were all accompanied by falls in equities.
A big reason for this is that inflation expectations and equities are both cyclical: they rise in better economic times and fall in worse. Another reason, though, is that a weaker pound raises both inflation expectations and the sterling value of overseas earnings, thus supporting share prices.
This is not to say that the correlation between break-even inflation and share prices must remain strong. It’s easy to imagine circumstances in which it could break down, such as a big rise in commodity prices, greater wage militancy, or if there are doubts about whether the inflation target will stay in place.
Would Brexit be one of these correlation breakers? I’m not sure. The fact that equities have so far been resilient in the face of fluctuations in the probability of a no-deal Brexit suggests not. Of course, it would hurt companies operating in the UK. But some of the pain will be felt by the UK subsidiaries of overseas companies, such as car manufacturers, and a lot of it will be suffered by smaller unquoted companies that lack the management capacity to cope with uncertainty, red tape and reorganising supply chains.
A second support for break-even inflation in the face of the threat of recession is fiscal policy. Last week, Chancellor Sajid Javid said he was “turning the page on austerity” by announcing big rises in public spending, which the next government, whatever it is, is likely to expand upon. This should support inflation expectations simply by boosting aggregate demand relative to what it would otherwise be.
In truth, though, break-even inflation should in theory be stable. If investors believe the Bank of England will stick to its inflation target then it shouldn’t move much from a tad over three percentage points – one percentage point to reflect the fact that RPI inflation is usually this much higher than consumer price index inflation (CPI), and a small amount more to reflect a risk premium because of the chance that a future government might change the inflation target, or that the Bank will not act to stop some temporary inflation caused by a weak pound or higher commodity prices.
And for the past three years, we have seen exactly this. Which in a sense is a nice paradox. The past few months have brought into question many UK institutions: experts, representative democracy, the 'liberal elite' and even the queen. And yet faith in the inflation target seems as strong as ever. It is odd that this should be an oasis of stability when so much else is uncertain.
