Long-term inflation expectations have also fallen decisively since early autumn. At that time, households expected inflation to average 5% over the next five years, while executives expected it to average 4%. At the same time, market agents expected inflation to average 3.6% over the next ten years.

According to newly published CBI surveys, households’ five-year expectations have fallen to 4.0% and corporate expectations are down to 3.5%. Similarly, market agents now expect inflation to average 3.0% over the next ten years. By all of these measures, long-term inflation expectations are at their lowest in two-and-a-half to three years. Given that these same groups of survey participants expect inflation to be slightly above the aforementioned averages in the immediate future, we can assume that long-term expectations are broadly within striking distance of the CBI’s 2.5% inflation target.

But while all of this is good news, we cannot declare victory just yet: long-term inflation expectations are still poorly anchored, as can best be seen in how volatile they have been in recent quarters. Anchoring expectations more firmly is a long-term project that will presumably require a higher real interest rate than can be seen in most neighbouring countries over the next few years.

Real rates are still high

The drop in inflation expectations should be welcome news to the CBI’s Monetary Policy Committee (MPC), whose members have repeatedly expressed concerns about high inflation expectations during their deliberations about policy rate decisions in the recent term.

However, lower expectations play a broader role than merely acting as a measure of public confidence in the CBI’s ability to fulfil its legally mandated role of keeping inflation in check.

Inflation expectations place nominal interest rates into context with small and large decisions on saving, consumption, and investment. If it is generally expected that interest rates will not keep pace with inflation, there is little incentive to save and a correspondingly greater incentive to spend and invest. Naturally, the reverse is true if it is generally expected that nominal interest rates will deliver a profit over and above inflation. The monetary stance set by the MPC is therefore determined not by where the nominal policy rate lies at any given time, but by where it lies in comparison with various measures of inflation expectations. Actually, the nominal policy rate is frequently compared to past twelve-month inflation as well, although this can be a misleading measure, as we have discussed in the past.

Examining the real policy rate according to various measures reveals that while the nominal policy rate has been lowered by 0.75 percentage points since the beginning of Q4/2024, the real policy rate has not fallen. On the contrary: it has inched upwards to its current level of 3.7-4.8%, depending on which measure of inflation expectations is used. In September of this year, however, it lay in the range of 2.1-5.0%. The various measures are now better aligned, and the average real rate is higher.

The same can be said of real rates as depicted in indexed bond yields and interest rates on CPI-indexed loans. For example, the yield on three-year indexed Treasury bonds is currently 4.1%, and the ten-year indexed yield is 2.6%. In mid-2023, when the CBI had concluded its monetary tightening phase and the nominal policy rate stood at 9.25%, yields on the same two Treasury maturities were just above 2%. By both measures, the real rate is also about the same as it was in early October, when the CBI first began unwinding the policy stance.

This high real rate is also reflected in mortgage lending rates. Lending rates on CPI-indexed mortgage loans with a three-year fixed interest rate clause are around 4% or slightly higher at present. As is the case with indexed Treasury bond rates, indexed mortgage rates have generally not fallen despite the decline in the nominal policy rate. Therefore, these rates, like indexed Treasury bond rates, reflect the real interest rate level in the economy and the increasingly tight monetary stance in the recent term despite the fact that the last policy rate hike took place in spring 2023.

Scope for further policy rate cuts in the near future

What implications do the above considerations have for the interest rate outlook? To put it succinctly, we are of the opinion that the high real policy rate reflects the leeway the CBI has for further nominal policy rate cuts in coming quarters. As we have discussed recently it would not be of critical importance in this regard if the disinflation process were to take a short breather in the next few months. Of greater significance are recent indicators from the labour market, the housing market, and other parts of the economy, which show that growth in demand pressures has subsided markedly and the economy as a whole is moving steadily towards greater equilibrium. Less expansion concurrent with more favourable inflation expectations should mitigate the need for a high real policy rate in the future.

The CBI’s next policy rate decision dates are on 5 February and 19 March 2025. All else being equal, we think it likely that the MPC will lower the policy rate on both occasions. For 2025 as a whole, we expect rate cuts totalling 2 percentage points, bringing the nominal policy rate down to 6.5% a year from now.