In my last European Perspectives in May, I suggested that life was about to get tougher for the Bank of England and the Monetary Policy Committee (MPC). Whilst I did, and still do, believe the MPC was unnecessarily aggressive in raising rates earlier this year, under no circumstances could I claim to have foreseen the turbulence that has beset the financial markets, and indeed the Bank itself over the subsequent months. I must admit to two things early on. First of all, my sympathy for the Bank of England and the MPC over what has clearly been a difficult period, and secondly, my hope and expectation that, in due course, they will do the right thing. In particular, I hope the well-publicised difficulties over recent months do not leave the Bank and the MPC feeling cornered and unwilling to react to events as they unwind.

The Trouble with Inflation
The issues surrounding Northern Rock and its subsequent impact on the broader UK economy are not what I want to cover in this article. Suffice it to say that in the broader context, I absolutely agree with Myles Bradshaw’s thoughts on the likelihood of a material slowdown in growth, but that is not in doubt any more. Rather, I would like to address the fundamental remit of the MPC, which is low and stable inflation, and ultimately whether the markets believe the MPC will reach its inflation target. If the markets do believe inflation will fall, then at least the MPC can cut rates to counteract the slowdown. If not, then we enter the less appealing world of sub-trend growth and sticky inflation.

Chart 1 reflects the yield difference between long maturity nominal and index-linked gilts. As you can see, that difference has been widening steadily for the better part of two years. Worryingly for the MPC, surveys of consumer expectations of inflation have also been widening steadily. So are we on the verge of another upward push in inflation at just the wrong time or will falling expectations, falling inflation and weaker growth open the door to lower interest rates in 2008?

Housing Divides CPI and RPI
Back in May, I focused on the pricing surveys, which were so worrying the Bank of England, but now these look to have turned for the better. We need to move our focus to the more market-based inflation gauges, which clearly still flash amber. To some degree, one can argue that the rise in inflation expectations is simply a lagged reaction to the rise in the Consumer Price Index (CPI) to above the 3% ceiling (although, interestingly, already back at the target) and the rise in the Retail Price Index (RPI), which – despite the protestations of the Bank – is still a key inflation gauge to many. For investors, index-linked bonds pay coupons linked to the RPI whilst for individuals many wage settlements and pension payments are linked to the RPI. Whilst the CPI may have already come back down to target, the RPI is still a lofty 3.9%. So, is RPI at 3.9% consistent with a 2% CPI level? Does the Bank care?

The main reason the RPI has diverged so much from the CPI is housing – the RPI contains both mortgage interest payments and housing “depreciation” (not much of that in recent years, but looking forward…?). These are not present in the CPI, but represent around 5% each in the RPI and are currently up at 24.9% year-on-year and 9.7% year-on-year, respectively. Interestingly, if you take these two components to zero, which will happen to mortgage payments unless the Bank raises rates, and is entirely plausible for house prices, the RPI would fall to 2.4% from the current 3.9%. At that level, the skepticism should ease as to whether the “true” inflation that impacts consumers and investors is so different from the CPI. If the most visible prices for consumers (housing) stop going up and if the inflation accrual for investors on index-linked bonds runs closer to 2.5% rather than the 3.5%, then my guess is that the current bout of inflation worry will dissipate. That, in turn, would give the MPC the flexibility to respond to the weaker economic backdrop.

More Price Sensitivity
Undoubtedly, the UK is not just about housing. Food and oil prices represent a key threat to the inflation outlook, but in each case there is some cause for comfort. Ironically, the fact that over half the price of a gallon of petrol is tax is good news during a period in which oil prices rise sharply – it does after all mitigate the impact of the 40% rise in the price of oil in Sterling terms. Similarly, food prices are clearly under upwards pressure. However, if anything, aggregate food price inflation has been easing of late as higher-margin processed foods come down. Indeed, we know that the UK consumer is regaining its price sensitivity as shown by the retail sales deflator falling back down to -1.5% in September after having been positive over the first half of the year. With that in mind, a sustained rise in commodity prices does pose a threat, but arguably a bigger threat to countries other than the UK.

The Place to Be
So what does that mean for us as investors? Well, the first point to make is that we do believe that the MPC will achieve its target of 2% CPI. We do believe that inflation expectations will come down, but only as the RPI moves back down toward 2.5%. Finally, we do believe that the combination of weak growth and benign inflation will allow the MPC to lower rates over 2008. To our mind, that suggests shorter bonds remain the best value on the curve and that there are cheaper markets than the UK to buy index-linked bonds. Yes, there is good structural demand for index-linked gilts but let’s face it: at 1% yield plus 2.5% inflation, these cannot be the best value across either the global index-linked markets or the broader fixed-income universe. Falling domestic inflation and a historically hawkish central bank is not the best backdrop for index-linked bonds. Indeed — if I am completely honest — my suspicion is that the MPC implicitly target a 1.75% CPI rate rather than 2%, but I will leave that one for another day.

Mike Amey
Executive Vice President