By Cedric Scholtes of the Bank’s Reserves Management, Foreign Exchange Division.
Prices of index-linked financial securities provide market-based measures of inflation expectations and attitudes to inflation risk. In the United Kingdom, ‘breakeven’ inflation rates derived from index-linked and conventional gilts reflect investors’ forecasts of future inflation, and also act as a barometer of monetary policy credibility. Implied breakeven inflation rates are a useful alternative to surveys and econometric forecasts, and are regularly presented to the Bank’s Monetary Policy Committee to inform its assessment of economic conditions. This paper outlines the technical and institutional factors that complicate the interpretation of UK breakeven inflation rates. Looking at data, we find that inflation expectations have fallen considerably since the adoption of inflation targeting and that UK monetary policy credibility is considerably stronger since the Bank of England was granted operational independence.