Inflation expectations are critical for investors considering inflation-linked bonds as a hedge against the effect of rising prices.

For example, the current yield on 10 years index-linked UK government bonds is 0.9%, compared to a yield of 3.3% on 10-year nominal bonds.

This shows that the market expects inflation to be 2.4% – the difference between the two rates. So investors with expectations that inflation will be above 2.4% should buy index-linked bonds, while those who expect inflation to be below that level should hold nominal bonds.

However, short-term inflation in the UK is currently at around 5%, according to the Retail Prices Index (RPI), or 3.2% according to the Consumer Price Index (CPI).

The difference between the indices is partly due to the greater weight that RPI gives to housing costs and partly due to calculation differences. While the two are closely correlated, CPI tends to produce a lower number, which is why the coalition Government wants to switch to it for index-linking public and private sector pensions.

Bond manager Pimco expects this change to reduce public sector pension liabilities by 10% and private sector liabilities by 5%; good news for companies and the Chancellor, if not so good for pensioners and scheme members.

Looking at the wider picture, it’s possible to ask if the market view of UK inflation at 2.4% is too low.

Many think that inflation is temporarily high, due to various one-off factors and that in time, spare economic capacity will damp it down.

On the other hand, some pundits believe low-interest rates and lax government policies will lead to inflation getting going, as it did in the 1970s. And inflation could be pushed up in the short-term by rising commodity prices caused by events such as poor harvests in Russia and elsewhere this year, or demand for better wages by Chinese factory workers.

But with a double-dip recession in the US and elsewhere now looking more likely and austerity policies being introduced by most European governments, inflation could be held at bay.

In which case, investors wishing to avoid the impact of inflation might well look beyond both the relatively low yields on index-linked and nominal bonds to consider a wider mix of assets.

Infrastructure and property are both being sold as offering hedges against inflation. If they can also provide capital gains then investors with a cautious outlook on inflation might find a place for them in their portfolios.

For bondholders such as pension funds, inflation expectations are a crucial aspect to consider when deciding whether to hold nominal or index-linked bonds.

In particular, bond investors need to differentiate between anticipated and unanticipated inflation.