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Markets are now discounting two quarter-point rate rises in the UK over the next year. While I have been more bearish than the consensus about interest rate prospects, I think a retightening of policy would be a mistake and is unlikely to occur.

The foundations of the current inflationary upsurge were laid in 2005-2007, when the broad money supply M4 was allowed to grow at a 12-13% annualised rate. To return inflation to the 2% target over the medium term, the rate of M4 expansion needs to be brought down to 6-8% pa. However, the slowdown should be gradual – a collapse in money growth would risk transforming a painful economic adjustment into an unnecessary bust.

M4 was still rising at an annual rate of 11.1% in April but has been inflated by financial transactions related to the credit crisis – see here. An adjusted measure proposed by the Bank of England grew by 9.0% in the year to March (the latest available month) and at an annualised rate of just 4.8% in the first quarter alone.

This slowdown is contributing to a dangerous liquidity squeeze on companies. Annual growth in M4 holdings of private non-financial corporations (PNFCs) has slumped from a peak of 16.1% last May to 1.0% in April. Relative to retail prices, real PNFC M4 is contracting at the fastest rate since the early 1990s, suggesting a growing risk of a slump in business spending – see chart.

With inflation and inflation expectations rising, the MPC has little choice but to sit on its hands for the foreseeable future. However, the Committee should resist pressure to compensate for its poor decisions in 2005 and 2006 by adopting an unduly restrictive policy stance now.

Bears were cheered by the latest US labour market report, showing a jump in the unemployment rate to 5.5% in May. On closer inspection, however, much of the rise was due to an expansion of numbers seeking work, particularly among people aged 16-24. (The unemployment rate for this group jumped from 11.0% to 13.0%; some reversal is likely next month.)

Employment trends are more relevant for assessing economic growth. Two measures are reported – one based on payrolls and the other on a survey of households (from which the unemployment rate is derived). Payroll employment has been falling since December but the household survey measure has been broadly stable – see first chart. The rate of decline of payrolls has been lower than during the 2001 and prior recessions. Allowing for productivity growth of about 2% annualised, recent developments remain consistent with GDP expansion, albeit sluggish.

Export strength, particularly to the emerging world, continues to support the US economy – the export orders index in the ISM manufacturing survey hit a four-year high in May. The second chart shows industrial output growth in the “E7” major emerging economies together with a composite leading index based on OECD data. (The OECD does not publish a leading index for Taiwan so the national index has been used instead.) Output rose by an estimated 9% in the year to April, which compares with sub-1% growth in the G7. The leading index suggests a  further slowdown over coming months but remains notably stronger than during prior global economic downswings.

As discussed in the last post, inflationary pressures are forcing monetary policy tightening in emerging economies. However, interest rates are currently below a “neutral” level in many countries and in some cases attempts to tighten are being frustrated by an expansion of liquidity due to currency inflows. (China’s foreign exchange reserves rose by $78 billion in April alone.) Policy restriction will eventually lead to a significant slowdown in the emerging world but this is probably a story for 2009-2010 rather than this year.

The further surge in oil prices is casting a cloud over prospects but the evidence to date is that the US and global economies continue to hold up better than most economists expected.

ECB President Trichet yesterday warned of a possible July rate rise, in line with the hawkish message from my ECB-ometer – see here. Any increase is unlikely to mark the start of a new trend, however. One reason is that the ECB’s policy stance is already reasonably restrictive – the current repo rate still exceeds headline CPI inflation and is comfortably above the core rate (i.e. excluding food and energy).

The same cannot be said of the US and many emerging markets. The chart below shows weighted averages of short-term interest rates and CPI inflation in our “E7” grouping of major emerging economies (Brazil, Russia, India, China, Korea, Taiwan, Mexico). Central banks in these countries are in tightening mode but in most cases look well “behind the curve” (exception: Brazil). Officials are reluctant to move aggressively partly for fear of excessive currency strength given the super-low level of US rates.

The Fed’s maxi-ease is creating global not just domestic inflationary headaches.

I have been critical of the Fed’s rate-slashing campaign between September and April. Rather than supporting the economy, the cuts have undermined the dollar and boosted commodity prices, thereby increasing inflationary risks. Fed Chairman Bernanke’s musings this week on the desirability of a stronger US currency appear to represent belated acknowledgement of such criticisms.

Talk is cheap but is the Fed prepared to adopt policies to support the dollar? As the first chart below shows, the US trade position is improving relative to Euroland, laying one of the foundations for a recovery in the dollar versus the euro. However, it may be difficult for the currency to achieve a meaningful gain given the large gap between real policy interest rates in the US – now negative – and Euroland.

One indicator that has provided advance warning of Fed policy shifts historically is the ISM manufacturing delivery times index. Lengthening delivery times signal rising pressure on supply capacity, which may warrant Fed tightening. The index has recently moved into the region associated with rate increases – see second chart. With this indicator and the dollar both suggesting tighter policy, will the Fed move quickly to withdraw stimulus if the economy recovers in the second half, as seems plausible?

My tentative expectation is that global growth indicators will stabilise this summer and improve during the second half, mainly reflecting a revival in the US – see yesterday’s post and here. The latest US purchasing managers’ surveys seem consistent with this scenario. As the first chart shows, the new business indicator rose to a seven-month high in May and is at a level historically consistent with GDP growth of about 2% annualised.

The improvement in the US surveys contrasts with a further deterioration in Europe – particularly the UK. A rotation of growth momentum back to the US would be consistent with my regional monetary conditions indicators, shown in the second chart. It would also fit with the outperformance of US equities relative to Europe year-to-date.

One risk to my global scenario is that European weakness will outweigh any revival in US momentum. Based on the latest surveys, the US effect seems likely to dominate. Also, business confidence is positively correlated across countries – this month’s US improvement could be precursor of a stabilisation in European indicators.

Previous posts have compared annual industrial output growth in the Group of Seven (G7) major economies with soft landing and hard landing scenarios, based on average experience in prior downswings over the last 40 years. I have been expecting an outcome closer to the soft landing path in 2008, with major economic weakness possibly delayed until 2009 / 2010 (see here).

Based on partial data, annual growth appears to have fallen below 1% in April but is still reasonably close to the soft landing scenario – see first chart. As suggested in my last update, the annual change could fall close to zero by mid year, reflecting further credit tightening and commodity cost increases in early 2008.

If the historical comparison is still relevant, growth should show some recovery in the second half and into early 2009. Prospects of such a pick-up have been damaged by the recent oil price surge but my survey-based leading indicator registered a small increase in May, consistent with a possible mid-year trough – see second chart. More data are clearly needed to confirm this scenario.

Historically, recoveries following soft landings have been of short duration, partly because inflationary pressures quickly re-emerge, necessitating policy tightening. As the first chart shows, the soft landing path turns down sharply from early 2009. Any improvement in global economic news during the second half should be regarded as temporary relief.

Like the ECB-ometer (last post), my MPC-ometer has shifted in a hawkish direction over the last month. The May projection was for a 6-3 vote for unchanged rates, with three doves; the outturn was 8-1, with only David Blanchflower voting for a cut. This month the model suggests another 8-1 decision.

Activity indicators have weakened further and are at a level historically consistent with a half-point cut. However, the impact on the forecast has been outweighed by ongoing deterioration in the model’s inflation components. Consumer inflation expectations, manufacturers’ price-raising plans, average earnings growth and future inflation discounted by gilt yields have all risen over the month.

The MPC will not have early access to the May CPI numbers. Given the possibility that these will show a rise in annual inflation to the 3.1% letter-writing level, even those MPC members with an easing bias are likely to be reluctant to join David Blanchflower in voting for a cut this month.

For comparison, the Sunday Times Shadow MPC also voted 8-1 to keep rates on hold this month, following a narrow 5-4 decision last month. The MPC-ometer has a slightly better record over the 20 months since its inception: its average error has been 1.6 quarter-point votes per month versus 2.7 for the Shadow Committee.

My ECB-ometer shifted from a tightening to an easing bias between late 2007 and early 2008, reflecting weaker economic news and financial market stresses. In early March, as the credit crisis moved towards a climax, it suggested a 40% chance of a rate cut at that month’s ECB meeting. The move has since reversed, however, as markets have normalised and inflation indicators have worsened.

Based on available data, the model suggests a 30% chance of a hike in official rates at next week’s ECB meeting – see chart. This compares with a small probability of a cut last month. The change is due to a combination of strong first-quarter GDP numbers, a further deterioration in both survey- and market-based measures of inflation expectations and a rebound in M3 growth. These developments have offset weakness in survey activity indicators.

It is too soon to expect a reappearance of “vigilance” but next week’s policy statement and press conference could signal a hawkish bias.

Market interest rate expectations have shifted dramatically as investors have reassessed near-term inflation prospects (discussed here). As recently as mid April, the gilt repo curve discounted a further fall in Bank rate to 4.0% by the end of 2008. By the time the Inflation Report was prepared in early May, the implied year-end level had risen to 4.6%. Poor April inflation data and the hawkish tone of the Report extinguished remaining hopes of reductions and the repo curve currently suggests a greater-than-50% probability of a quarter-point hike by December.

Market rates are now starkly at odds with economists’ forecasts, which have adjusted much less to recent news. In a Reuters poll conducted in mid April, 53 out of 56 respondents projected a further fall in Bank rate by the end of 2008, with a mean forecast of 4.43%. By mid May, the number expecting a decline had fallen to 45 out of 53, with the mean rising to 4.61% – still consistent with at least one quarter-point reduction. Strikingly, higher near-term expectations have been balanced by a lowering of projections further ahead – the mean forecast for the third quarter of 2009 fell from 4.37% to 4.33% between the April and May surveys.

So who is right – the market or economists? One way of approaching this question is to use the “MPC-ometer” model described in earlier posts to forecast Bank rate decisions over the remainder of 2008 assuming the economy performs in line with the MPC’s expectations. Specifically, suppose 1) GDP growth and CPI inflation follow the paths shown in the unchanged rates scenario in the May Inflation Report, 2) business and consumer confidence fall to levels consistent with the growth projection and 3) all other components of the MPC-ometer – including inflation expectations, earnings growth, equity prices and the effective exchange rate – remain at current levels. On this basis, the model indicates a 65% probability of rates remaining at 5.0% until the end of 2008, with a 35% chance of a quarter-point cut.

Put another way, economists’ expectations of one or two more quarter-point reductions before the end of 2008 depend on either growth and / or inflation undershooting the MPC’s forecasts or other components of the model shifting in a favourable direction. Neither seems particularly likely. The MPC’s growth projections are already downbeat, with GDP forecast to rise by just 0.9% in the year to the first quarter of 2009, while its expectation of a 3.7% peak in annual CPI inflation looks conservative. (This assumes a further 15% rise in retail electricity and gas costs but current wholesale energy prices suggest a larger increase.) Of the other model components, consumer inflation expectations and earnings growth are unlikely to fall back while the headline CPI rate is climbing, although a weaker economy may temper business price-raising plans. Lower equity prices and / or a rally in the exchange rate could boost easing hopes but neither carries strong weight in the MPC’s decisions, according to the model.

Monetary trends are also important for judging prospects for further rate cuts. Broad money M4 has continued to grow rapidly in recent months but appears to have been distorted by the credit crisis. Concerned about counterparty risk, banks have reduced traditional unsecured interbank lending in favour of secured loans, particularly gilt reverse repos. Unsecured lending is excluded from M4 but increasing repo activity may have boosted the aggregate because it is intermediated by the London Clearing House (LCH), which is classified as part of the non-bank private sector. The Bank of England has constructed a modified M4 measure excluding money holdings of the LCH and other financial corporations used to conduct interbank business (see p.18 of the May Inflation Report). This rose by 9.0% in the year to March and by 6.1% annualised in the latest six months (see chart) versus comparable growth rates of 11.9% and 9.6% for total M4. The gap between the two measures is likely to widen as a result of Special Liquidity Scheme (SLS) introduced in late April, which should significantly boost interbank repo transactions. It will therefore be important to focus on the adjusted measure rather than headline M4 to assess monetary conditions over coming months. (Unfortunately, the new measure is available only on a quarterly basis, with the next reading for June due in early August.)

Summing up, the MPC-ometer analysis supports market scepticism about economists’ forecasts of further Bank rate cuts later in 2008 but suggests a reduction is more likely than a rise. On this basis, current longer-term money market rates offer value – particularly unsecured rates, since credit / liquidity spreads should be capped by the SLS. Monetary trends are also consistent with a stable policy stance but a further slowdown in adjusted M4 would suggest improving medium-term inflation prospects, warranting consideration of a rate cut in late 2008 or early 2009.