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Expecting falling inflation

Inflation is mostly temporary – according to the gilt market. The five-year breakeven inflation rate (the gap between conventional and index-linked yields) is now 4.7 percentage points. That compares to a current retail price index (RPI) inflation rate of 9 per cent, implying that markets are pricing in a big drop in inflation. In fact, by comparing three-, four- and five-year breakeven inflation rates we can calculate the implicit breakeven inflation rates for the 12 months to May 2026 and May 2027. For both years it is 3.7 per cent. If we allow for the fact that RPI inflation is typically above consumer price index (CPI) inflation (by an average of 0.9 percentage points a year in the last 10 years) this implies that the market expects CPI inflation to fall below 3 per cent. That’s above the Bank’s target, and above the Bank’s own forecasts, but no great problem.

Which poses the question: what does the gilt market know about future inflation anyway?

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