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INVESTMENT FOCUS-Markets cast doubt on UK's inflation goals
October 28, 2016 / 12:50 PM / a year ago

INVESTMENT FOCUS-Markets cast doubt on UK's inflation goals

* Breakevens suggest BoE will not hit target for 50 years

* But may be distorted by range of factors

* High expectations creating “vicious circle”

* Speculation that Britain may change targets

By John Geddie and Abhinav Ramnarayan

LONDON, Oct 28 (Reuters) - If financial market gauges are to be believed, Britain will struggle to keep inflation in check for the next half century.

Those signals are likely distorted by other factors, but they are contributing to questions over the Bank of England’s ability to contain inflation as Britain prepares for an era of economic uncertainty outside of the European Union.

Having watched sterling crash to a 31-year low against the U.S. dollar on Brexit fears, the BoE will likely next week jack up its inflation forecast to show a bigger overshoot of its price target than any time since it gained independence in 1997.

In its August forecasts, the BoE already predicted inflation of 2.4 percent in two and three years’ time, above its 2 percent target. Since then, sterling has fallen further on worries that Britain will take a hard-line approach to the Brexit talks.

For Britain’s monetary guardians, dealing with rising inflation could be difficult. Its ultra-easy approach has been criticised by some lawmakers while tightening conditions could risk choking off economic prospects altogether.

Economists are keeping a fairly cool head on near-term price prospects for now, and no one is expecting a return to the double digit inflation of the 1970s and 1980s. Like central bankers, they tend to look through blips caused by factors such as currency depreciation. But long-term worries are creating some concerns among investors.

“The long-term inflation forecasts are high and that then increases the urgency of having to protect yourself against inflation, so it can become a vicious circle,” said John Walbaum, head of investment at consultancy Hymans Robertson.

Over the past decade, inflation has overshot the BoE’s target eight times, and by more than 0.5 percent on five occasions, according to the Office for National Statistics.

Several economists with leading international banks have said they expect prices to peak around 3 percent at the end of 2017, lower than 5 percent seen after the financial crisis and bouts of more than 15 percent seen in the 1970s and 1980s.

For longer-term forecasts, market pricing is seen as one of the only signals, specifically breakeven rates on inflation-linked bonds. Breakeven rates - the difference between real yields on inflation-linked bonds and nominal bond yields - indicate the average rate of inflation needed for an inflation-linked bond to be a better investment than the regular bond.

Inflation-linked bonds are indexed to retail prices, which economists say is roughly around 1 percent higher than consumer prices, implying that a breakeven rate of around 3 percent suggests the BoE is hitting its target.

Fifty-year breakeven rates are currently around 3.5 percent .

Some economists say the fall in the currency since the Brexit vote is likely to blame, raising the risk that average inflation rates could stay elevated for many years.

“The market is pricing in a short-term overshoot in inflation and that may be reflected all across the curve, even at maturities that you may not expect,” said Sam Hill, senior UK economist at RBC Capital Markets.

DISTORTIONS

Furthermore, gauges the BoE itself uses to get a handle on the long-term path for inflation and which strip out near-term prices moves, are flashing some warning signs.

The five-year, five year forward breakeven rate - a derivative that measures where inflation might average between 2021 and 2026 - is trading at 3.6 percent.

These gauges could be distorted by other factors, most notably a mismatch between the amount of inflation-linked bonds in circulation and demand from the likes of pension funds that need to hedge against rising prices.

At around 1.5 trillion pounds, the assets in defined benefit pension schemes in Britain are more than three times the size of the UK inflation-linked bond market.

At a time when other investors are also looking to protect themselves against inflation, this demand has exacerbated the fall in real yields and widened breakevens.

“It is hard to point to any one single factor ... given how sentiment has shifted since the Brexit referendum. But the one constant keeping inflation-linked bond yields lower is the tremendous demand from pension funds,” said Jonathan Crowther, head of liability driven investment at AXA Investment Managers.

Pension funds have lobbied the UK debt agency to sell more inflation-linked bonds to ease this problem, and it could be given more room to do so if it is given the green light for more borrowing by finance minister Philip Hammond in next month’s Autumn Statement.

Some say the heating up of the market gauges could even be reflecting speculation that Britain, at some stage over the next couple of decades, decides to move the goalposts for its inflation target to accommodate higher prices.

Central bankers across the developed world have debated the potential benefits of raising inflation targets in recent years to underline their determination to avoid a deflationary trap.

“We are coming out a period of very low inflation globally so it may seem odd to suggest that central banks’ inflation targets are not necessarily cast in stone forever, and maybe there are arguments for them being higher,” said Dariush Mirfendereski, global head of inflation trading at HSBC. (Editing by Alison Williams)

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