Asset price reactions to RPI announcements

This paper examines the same-day reaction of a variety of UK asset prices to monthly RPI inflation announcements over a sample period extending from the early 1980s until April 1997, the month before the Bank of England was given operational independence for setting interest rates. These announcements are decomposed into their expected and unexpected, or 'news', components using survey data on financial analysts' inflation expectations and, as a cross-check, prediction errors from a time-series model of inflation. It is found that markets are efficient, in that asset prices do not respond to the expected component of RPI announcements. Generally, only government bond prices are sensitive to inflation news, and this sensitivity appears particularly marked after late 1992, when the UK adopted an explicit inflation target. The responsiveness of implied medium and long-term forward inflation rates (calculated from conventional and index-linked bonds) during the post-1992 period is consistent with the expected inflation hypothesis, a result that suggests that the pre-independence inflation-targeting framework was not seen as fully credible by the financial markets. Nevertheless, the declining responsiveness of bond yields and implied forward inflation rates to inflation news over the period of operation of the framework suggests that its credibility improved over time.