Views from the LDI Desk – March 2025

UK Inflation – the short and long of it

7 minute read

Inflation continues to be a focus area in the UK in both the short and long term. In this piece we revisit recent drivers in UK Inflation, along with some long-term structural aspects impacting supply and demand in the context of defined benefit pensions.

Short-Dated Inflation

The UK CPI inflation print for January 2025 came in at 3%, modestly beating market expectations and the BOE’s forecast. This outcome was largely driven by higher-than-expected food inflation, while energy inflation eased more than anticipated.

Within the core basket, services continued to show signs of stickiness, rising from 4.4% to 5.0% year-on-year, partly driven by stronger transport services and a jump in education prices following the introduction of VAT on private school fees. Meanwhile, core goods inflation accelerated from 1.2% to 1.6% year-on-year, indicating mounting pressure in non-service sectors. Looking ahead, the Bank of England (BoE) is projecting a temporary spike in inflation to around 3.7% in Q3 2025, driven by rising energy costs and regulated price increases, before easing toward its 2% target by 2027.

Given the current mix of persistently sticky services inflation, strong wage data, and accelerating core goods inflation, the BoE appears likely to maintain a gradual approach to rate cuts, pending further developments in growth and labour market conditions. In February, the Bank of England cut the Bank Rate by 25 basis points to 4.5%. Whilst this was in line with market expectations, the surprise was two members voting for a 50bps cut. Despite persistent challenges in lowering rates due to high inflation and wage growth, signs of a weakening UK economy are emerging. As we previously wrote in February 2025 deteriorating forward-looking indicators—such as softer PMIs—and now an unexpected 0.1% contraction in GDP for January point to a more subdued economic outlook. This evolving environment may pave the way for additional rate cuts, with the market currently pricing in two more 25 basis point reductions this year. February’s data on wages and inflation will be a key factor ahead of the next meeting.

Inflation curve and basis (IOTA)

Over the past 12 months we have witnessed a noticeable flattening in the inflation curve between 10-year and 30-year swap inflation, as well as between 10-year and 50-year inflation expectations, as the impact of higher inflation in shorter tenors has fed through. These spreads have fallen to their lows over this period, signaling a flattening of the inflation curve.

Furthermore, this has not been a consistent story in Index-linked Gilts with long-dated Break-even Inflation outperforming RPI swaps. Notably long-dated IOTA (the difference between Swap and Gilt based breakeven inflation) has continued to fall as we have seen continued demand for Index-linked Gilts in the Insurance sector where they’re seeking high-quality assets in a period where credit spreads remain particularly tight.

On 12 March 2025, the final syndication of the fiscal year featured the new Index-linked Gilt 2049s. Priced 1bp above the 2048s, the bond generated a record order book of over £67.5 billion and was upsized from expectations of £4-4.5bn to £5bn despite cash constraints, with sovereign wealth funds, hedge funds, and traditional asset managers driving demand. The order book was composed of a wide investor base, taking advantage of the appealing elevated real yields. While prior to 2022, longer Index-linked gilt syndications were more heavily subscribed by DB pension schemes.

Update on the RPI-CPI Basis

As we gradually approach the implementation of RPI reform in February 2030 one aspect worth focusing on is whether the market is reflecting this shift more broadly. By way of reminder, RPI Reform will align the calculation methodology of RPI with the Consumer Prices Index including owner occupiers’ housing costs (CPI-H).

We can split this into three components:

• Post 2030, RPI and CPIH should be equal as the calculation of RPI is aligned to CPIH
• Differences will exist between CPI and CPIH driven by the differing calculation of CPI and CPIH, namely the owners occupiers housing element “H”
• Differences between market expectations of CPI and the Bank of England target of 2% (i.e. some form of Inflation risk premium or market implied view on the path of inflation)

The basis between CPI and CPIH was discussed in the Views from the LDI desk in December 2024, with this basis recently elevated. This piece also mentioned that: “CPI and CPIH have tended to track more closely, with the average basis between now and 1989 at just 5bps, reflecting the aligned formulae used in the two measures.” We are seeing post 2030, the difference is c-0.2% to 0.2% depending on tenor, therefore looking broadly in line with fair value.

Finally, the chart below shows the current CPI 1y forward curve, relative to the BoE inflation target of 2%, on average we see an average premium of c.80bps. Note that historically the difference between realised CPI and the central bank target has sat around 20bps – if we exclude the recent period of materially high inflation post-Covid. This may change overtime driven by a range of factors but highlights that the market is currently pricing a relatively large premium above the 2% BoE target, relative to what has been seen historically. This premium may be due to supply and demand dynamics in the index-linked gilt market or doubts about the ability for the BoE to hit their inflation target in the longer term.

Longer terms factors impacting supply and demand in UK inflation markets

Pension schemes have historically driven the bulk of demand for Index-linked Gilts. Below we assess how some recent changes may impact this over the medium term.

Shifts in Mortality

The Continuous Mortality Investigation (CMI) at the Institute and Faculty of Actuaries has suggested major changes to the CMI Model for the upcoming CMI_2024 release. The consultation on these changes is ongoing, with an update expected in April. Under the new model, life expectancies at age 65 would increase by about five weeks for males and decrease by about one week for females compared to CMI_2023. The chart below displays life expectancy as per CMI models up to 2023.

Whilst the latest CMI appears to buck the trend of deteriorating mortality many Schemes in the midst of their triennial valuations will find that their liabilities shorten as a result of the longer impacts from CMI_2021 tables and later, the impact of moving from CMI_2021 to CMI_2022 or 2023 was material, this was due to how the data during the COVID pandemic was considered, and the estimated impact of moving from CMI_2021 to CMI_2022 could be a fall in liabilities as large as c.2% for a typical DB pension scheme. This would likely reduce remand for longer dated gilts.

How does the current universe of gilts compare to the total UK DB pension scheme liabilities?

We can look at the aggregate demand for Gilts from a DB Pensions context by creating a proxy of liabilities using the PPF Purple Book 2024 on a solvency basis and comparing this to the current universe of Gilts and Index-linked Gilts.

The charts below highlight the profile of DB liabilities relative to the current universe of Gilts and Index-linked Gilts. We highlight a few observations.

• The current Index-linked Gilt universe reflects the profile of DB liabilities well. And although issuance has reduced in recent years as a % of total Gilt issuance, the net supply of Index-linked Gilts remains close to its record high. This will be an area where a shift in the Debt Management Office Remit may have consequences of the relative pricing of Index-Linked Gilts moving forward.
• On the conventional side, there is a significant supply of gilts at the short end which is a function of the broader investor base such as bank treasuries, insurers and overseas investors. In addition, Pension schemes often hold credit at the shorter maturities or derivatives, which indicates that the short end oversupply is even more pronounced.

Is this trend likely to persist in the future?

Post gilt-crisis, many schemes are experiencing high funding levels, and ultimately high hedge ratios across Interest Rates and Inflation. Moving forward, it’s likely that DB Schemes will not remain the structural buyer of Long-Dated Gilts, In addition, it’s likely that demand will shift from the more yield agnostic stable pension scheme investor base to one that is more yield sensitive, looking to embrace higher yields available from Index-linked Gilts in comparison to their history (the chart below puts this into perspective displaying the real-yield of a 30 year Linker). As mentioned earlier, the recent syndication of the new linker 49, shows strong demand from other investors who are seizing the opportunity for appealing real yields and asset swap levels, such as UK based and overseas insurers.

These factors mean the DMO may have to grapple with limited additional hedging demand from pension schemes in future, meaning they may need to change tact given their ability to issue longer dated conventional gilts and longer dated Index-linked gilts will become more constrained. All eyes will be on the Spring Statement on the 26^th March and the corresponding gilt remit.

What about the transitory factor of rebalancing inflation hedges due to LPI liabilities?

As an example, we can consider a stream of LPI(0,5) cashflows with a duration of 11yrs (broadly aligned to the duration of solvency liabilities in the 2024 PPF Purple Book). Consider that these cashflows have been calibrated using market conditions as at end December 2023 and end December 2024, how would the inflation sensitivity differ based on an assumed fixed inflation volatility assumption?

Here we can see that the change in outright risk is largely driven by the short end and ultra long-end where inflation has nudged nearer the cap leading to these cashflows having less inflation sensitivity. This demonstrates how LPI linked liabilities as ascribed between real RPI linked cashflows and nominal cashflows may have materially changed due to market movements over 2024.

Key takeaways for pension schemes:

• Revisiting liability benchmarks can be a useful exercise, whether that’s reflecting shifts in LPI or more recent mortality experience. Ensuring that you are hedging the latest benchmark and deciding an appropriate tolerance for the liability benchmark to be updated
• Schemes should be considering their approach to Inflation hedging particularly with the shifting dynamics in the supply and demand of Index-Linked Gilts and a potential implied inflation risk premia post RPI reform. For example, what actuarial assumption are being used for inflation risk premia and how does that compare to a market view?
• Structural drivers in supply and demand are likely to lead to greater opportunities to identify and pick up relative value opportunities. It is worth considering whether you can make you LDI portfolio work harder by introducing these aspects into the mandate.
• Inflation remains sticky in the UK and mega trends such as the energy transition, demographics, security and defence, along with shifting tariffs may justify a premium for inflation.