The surprisingly dovish February Inflation Report suggested a shift in the Bank of England's priorities towards supporting growth in the face of coming fiscal tightening rather than achieving its formal remit target of a 2% annual CPI increase "at all times". The Bank, of course, justified its stance by projecting a future fall in inflation but its forecasts have little credibility, having been overshot persistently in recent years.
Markets, it appears, agree that the Bank's inflation-fighting commitment has softened. The yield gap between conventional and index-linked gilts of between five and 15 years' maturity – a proxy for long-term market inflation expectations – has risen steadily from a short-term low the day after the Inflation Report, yesterday reaching its highest level since October 2008. US market-implied inflation expectations are little changed over the same period – see first chart.
Sterling, meanwhile, has fallen by 4% both against the US dollar and in trade-weighted terms since the Report. Coupled with renewed strength in dollar commodity prices, this has resulted in an 11% surge in industrial raw material costs, as measured by the Journal of Commerce index in sterling terms – second chart. Input costs are 60% higher than a year ago.
The Bank is now in a bind. Markets are rebelling against its dovish shift and their reaction further increases the risk of a sustained inflation overshoot, warranting consideration of an early Bank rate hike. This would be highly contentious given the imminent election and weather-depressed economic reports but policy inaction could result in an extension of recent market moves, ultimately forcing the Bank's hand.
