How do you measure inflation expectations? One answer is simply to ask people, and some indicators, such as the University of Michigan survey, do just that. But a more “scientific” approach is to use the markets, specifically to measure the gap between the real yield on index-linked bonds and the nominal yield on conventional bonds.

In the US, this “breakeven” rate has showed fairly subdued inflation expectations, with long-term bonds indicating an annual rate of just 2.7 per cent. That is in contrast with the Michigan survey, which recently showed a sharp jump to more than 4 per cent (albeit, only over the next year).

However, Tim Bond of Barclays Capital points out that the breakeven rate has actually been a very poor indicator of the actual US inflation rate. Looking at the 2007 issue, actual inflation has averaged 0.84 per cent more than the breakeven rate had forecast 12 months previously. This is in contrast with the UK and France, where breakeven rates have been within a quarter of a percentage point either way of the inflation out-turn.

Bond adds that the total returns from US inflation-linked bonds, or TIPS, have exceeded returns from conventional Treasuries by a cumulative 10.3 percentage points since the start of 2003. Of this, nearly eight percentage points is due to inflation, illustrating that investors underestimated the pick-up in prices.

This period coincided with a sudden step-change in the pace of accumulation of central bank foreign exchange reserves. annual growth increased sixfold between 2002 and early 2004. Much of this reserve growth has been channelled into conventional Treasury bonds.

It is far more common for central banks to own conventional rather than index-linked bonds. Joachim Fels, the Morgan Stanley strategist, says that “while acknowledging that inflation-linked bonds were a good diversifier in portfolios, reserve managers believe it would send a strange signal if they invested in such products as it would send a signal to markets that they don’t trust their own peers to keep inflation in check.” While this distortion remains, Barclays’ Bond argues that other asset classes may give a better steer on market inflation expectations.

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