MNI POLICY: Market Inflation Signals Mainly Noise, BOE Finds

Bank Of England research has cast doubt on the reliability of shorter-term market-based measures of inflation expectations often cited by policymakers as factors in their interest-rate-setting deliberations.

Some 80-90% of price variations in the shorter end of the fast-growing UK inflation swaps market are driven by changes in liquidity rather than by perceptions of economic fundamentals , with hedge funds major players, according to ongoing research using transaction-level regulatory data by the BOE’s Robert Czech and BOE- and LSE-affiliated Ricardo Reis and Sitong Ding.

Monetary Policy Committee members Catherine Mann and Dave Ramsden, among others, have referred to inflation swap prices in commentary on whether monetary policy is delivering price stability, but the research suggests that extracting an inflation expectations signal from the shorter end of the market is fraught with risk.

The transaction data show that hedge funds have become increasingly active in shorter-end contracts out to three years since the Covid shock and the subsequent resurgence of inflation, deploying arbitrage and other trading strategies that leave them with no net positions.

BETTER SIGNAL AT LONGER END

In contrast, the long-end of the inflation swaps market, covering terms outside the horizon of monetary policy and which is dominated by dealer banks selling inflation protection to pension funds and liability-driven investors (PFLDIs), does reflect inflation expectations much more closely, with changes in fundamentals accounting for 70-80% of price changes.

The signal from this longer end of the market is that inflation a decade ahead should be close to the BOE’s 2% target, rather than of any move into a new, higher-inflation world. In contrast, the year-ahead swaps measure has veered between signalling RPI inflation of 12% and 4%.

Recent commentary has cited variations in this large gap between 1-year and 10-year measures of expected inflation in the UK and the U.S. as an indicator of the likelihood of high inflation proving temporary, but the distortions in short-end pricing make this approach less useful, the research shows.

PFLDIs typically operate at 10-year-plus dates, buying inflation protection from dealer banks, with transactions thin at medium-term horizons. While serious liquidity constraints distorted the long-end market in recent shocks, such as at the onset of Covid, when it exaggerated the risk of long-term deflation, and during last year’s LDI crisis under the short-lived former premiership of Liz Truss, when it signalled persistently high inflation, its underlying inflation signal remained anchored, the research shows.

“Short-horizon price movements are unreliable measures of expected inflation as they primarily reflect liquidity shock,” the researchers stated in a working paper published last month, “Long-horizon expected inflation in the absence of these shocks suggests that the risk of a deflation trap during the pandemic and of a persistent rise in inflation following the energy shocks were overstated, while since autumn 2022, expected inflation has been lower and falling more rapidly than conventional measures.”

The BOE researchers used three identification techniques to separate fundamentals, risk and liquidity in pricing and found similar results with each of them. Reis, an adviser to the BOE and other central banks, has noted that as households tend to be unresponsive to central bank messaging and markets highly responsive, it is natural for central banks to look to market pricing though his research indicates that its signal is very blurry.