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The MPC’s Paul Fisher is reportedly “nervous and worried” about UK consumer prospects. Given the Committee’s forecasting record, it will be no surprise if consumer indicators rebound over coming months.

Consumer spending weakness, of course, has been mostly due to surging prices, for which the MPC bears significant responsibility. The first chart compares three-month growth of retail sales value and volume. Value expansion has remained solid over the winter and spring, with a volume decline explained by the inflation spike.

Slumping consumer confidence and downward pressure on real household disposable income may be yesterday’s story. Real income should recover in 2012, reflecting recent higher pay settlements, a mechanical drop in inflation, further employment gains and a reduced drag from fiscal tightening.

Consistent with confidence bottoming, households were less pessimistic about their finances in May, according to the monthly Markit survey – current and future indices were at their best levels since January. Retailing shares, meanwhile, have outperformed the market by a further 7% over the last month. The recent fall in oil prices, if sustained, promises some relief to strained budgets – second chart – while Which? estimates that payment protection insurance compensation will transfer £7.9 billion from banks to consumers, equivalent to 0.8% of annual disposable income.

US monetary trends suggest that the economy will perform solidly over the remainder of 2011, limiting the extent of the current global slowdown focused on Asia / emerging markets and Euroland.

The first chart shows six-month changes in US industrial output and real narrow money, defined here as currency plus demand deposits. Despite recent faster inflation, six-month real money growth remains strong at more than 5% in April, or 11% annualised.

The forecasting approach here has emphasised narrow money since the financial crisis on the grounds that the demand to hold broad money has been depressed by super-low interest rates. Broader aggregates, however, are also looking better. A wide liquidity measure comprising currency, bank and thrift deposits, money market funds and commercial paper has surged over the last three months – second chart.

Monetary strength, of course, partly reflects QE2 but any slowdown after securities purchases end in June will affect the economy only from early 2012. Improving credit trends, moreover, should limit monetary weakness: recent solid expansion of commercial and industrial loan books could presage a pick-up in overall bank lending – third chart.

Investors are debating whether recent weakness in industrial commodity prices is the beginning of a lasting move reflecting “fundamentals” or a temporary set-back, possibly due to disruption caused by the Japanese earthquake or a liquidation of QE2-related speculative positions. The balance of evidence seems to favour the former view:

1. Commodity price fluctuations are mostly explained by shifts in industrial demand in emerging economies. The close correlation of six-month changes in prices and E7 industrial output suggests little role for financial speculation – see first chart.

2. QE2 has probably boosted commodity prices but the “transmission mechanism” has been an unwarranted loosening of monetary conditions in emerging economies and resulting excessive industrial expansion rather than direct financial investment.

3. Accordingly, the set-back in commodity prices is evidence that emerging-world economic expansion is slowing, probably as a result of domestic monetary policy tightening designed to offset the inflationary effects of QE2. This fits with recent weaker E7 real money supply growth and a proliferation of earnings downgrades by equity analysts – second chart.

4. The global implications could be benign. Emerging economies have driven a strong global recovery but are overheating and need to slow, implying that developed economies must bear more of the burden of sustaining growth. A fall in commodity prices transfers purchasing power from the emerging world to developed market consumers, aiding the necessary transition.

5. A key risk is that China and other emerging economies declare premature victory over inflation, with policy relaxation leading to renewed overheating and upward pressure on commodity prices.

Growth “rebalancing” between emerging and developed economies suggests a slower overall pace of expansion, consistent with experience at the same stage of the late 1970s upswing – see previous post. For equity investors, the implication could be a further rotation away from materials and energy towards sectors likely to benefit from a recovery in developed economies’ terms of trade, including consumer goods, consumer staples, health care – and even financials.

As expected, lower growth in the inflation-adjusted global money supply since last autumn has resulted in a loss of economic momentum and a correction in equities. The economic slowdown, however, seems likely to be contained, suggesting that equities will trade in a range rather than weaken significantly:

• Six-month growth in G7 real narrow money remains positive and, based on US and Japanese data, may have picked up in April, hinting at a rebound in economic momentum later in 2011 – see first chart.

• Commodity prices are coming off the boil as emerging-world industrial expansion slows, promising real income relief for G7 consumers. Current oil prices imply a significant fall in retail petrol costs – second chart.

• A rally in bonds is also offering support to the economy, with lower yields feeding through to mortgage rates – UK five-year fixed rates have fallen back below 4% (75% LTV).

Downside economic risks focus on Euroland and China / emerging markets, where monetary trends remain worrying – see Monday’s post and third chart.

Narrow money, M1, is usually the best monetary leading indicator of the economy but broader measures provide corroborating information. In the US, “money of zero maturity” (MZM) – comprising instant-access forms of money* – slowed around year-end but has revived more recently, rising at an 11% annualised pace in the latest 13 weeks. As well as suggesting economic reacceleration, the MZM surge is flashing a warning signal for Treasuries – fourth chart.

* MZM = M1 + savings deposits + money funds.

CPI inflation of 4.5% in April was far above expectations, more than reversing a fall from 4.4% to 4.0% between February and March. The late timing of Easter depressed the March number and boosted April’s reading, mainly via a surge in annual inflation of air and sea fares – this should reverse in May. This effect aside, a further fall in food inflation was a favourable surprise but was offset by a pick-up in housing services, reflecting rents and water / sewerage charges.

Overall, the “news” relative to the assumptions embodied in the inflation projection presented in a post last week is limited – any revision will await May figures, which should clarify the Easter effect.

The rise in CPI inflation was not confirmed by the previously-targeted RPIX measure (i.e. RPI excluding mortgage interest costs), which eased from 5.4% to 5.3%. RPIX assigns a lower weight to air and sea fares and a higher weight to car insurance – premium increases are slowing. House prices and council tax, additionally, are exerting a drag on RPIX relative to CPI. RPIX inflation has tended to lead in recent years – see chart.

Relative monetary trends suggest that Eurozone GDP outperformance in the first quarter of 2011 will give way to significant underperformance later in 2011.

Eurozone GDP rose by 0.8% in the first quarter versus 0.4% in the US and 0.5% in the UK, with Japanese figures this week expected to show a contraction. Economic performance reflects monetary trends six to 12 months earlier. In the year to June 2010, real narrow money, M1, rose by 7.7% in Euroland versus 3.5% and 2.7% in the US and Japan respectively.

Monetary indicators, however, have since performed a U-turn. Real M1 rose by 8.4% and 5.0% in the US and Japan in the year to April but by only 0.3% in the Euroland in the year to March (the latest available month). This suggests strong economic growth in the US and Japan in late 2011 while Euroland slows sharply or even contracts.

Within the Eurozone, real M1 deposits fell by 4.2% in peripheral economies (i.e. Greece, Ireland, Italy, Portugal and Spain) in the year to March while rising by 3.4% in the “core” (i.e. Austria, Belgium, France, Germany, Luxembourg and the Netherlands). The contraction in the periphery is on the same scale as occurred before the 2008-09 output slump.

In the core grouping, the annual rise of 3.4% compares with 11.9% in June 2010 while real M1 has declined over the last six months. Eurozone economic weakness later this year, therefore, is likely to reflect a big slowdown in the core, including Germany, as well as stagnation or renewed recession in the periphery.

The chart shows an update of a monthly CPI inflation profile presented in a previous post together with the Bank of England’s mean forecast based on unchanged policy, estimated from chart 5.13 of the May Inflation Report. Assumptions underlying the profile include:

• “Core” prices – defined here as the CPI excluding unprocessed food and energy – rise at a 2.25-2.5% annualised rate, in line with an estimate of the trend leading into the recent VAT hike.

• 90% of the VAT rise has been passed onto consumers, consistent with evidence from the Bank of England agents’ survey – higher pass-through implies a larger mechanical fall in inflation next year as the impact drops out.

• Household energy bills rise by 7.5% over the next 12 months.

• Unprocessed food inflation peaks at an annual 6% in mid 2011 and slows to 3.5% in 2012.

• Bank rate is raised to 2% next year, contributing to core inflation remaining stable despite a further rise in capacity utilisation as the recovery continues.

• Undergraduate tuition fees add 0.2 percentage points to inflation from late 2012, as discussed in a previous post.

On these assumptions, inflation is projected to peak at 4.6% later this year before falling back below 3% in early 2012. The average between April 2011 and June 2012 is 0.6 percentage points lower than in the Bank’s forecast, showing a quarterly peak of more than 5%. The profile, however, is higher from late 2012, with inflation stabilising at about 2.75% versus the Bank’s 2.5%.

Reasons for these differences include:

• The Bank’s forecast incorporates a larger rise in household energy bills, of about 12.5% rather than 7.5%. The latter takes account of the recent correction in wholesale energy prices and assumes that slower emerging-world growth will relieve upward pressure over the remainder of 2011.

• The Bank assumes lower VAT pass-through of about 75% rather than 90%, despite the evidence from its own agents, resulting in a smaller favourable base effect on inflation in 2012.

• The Bank’s lower forecast from late 2012 reflects its view that spare capacity remains significant and will bear down on core inflation, despite limited evidence of such an impact to date. The Bank’s medium-term numbers would be closer to 2% if based on the assumption of a rise in Bank rate to 2% in 2012.

While inflation is likely to remain well above the target for the foreseeable future, a significant fall next year should contribute – with rising wage growth and employment – to a rebound in household real income, in turn supporting prospects for consumer spending and GDP expansion.

Japanese bank reserves surged in the wake of the 11 March earthquake / tsunami as the Bank of Japan supplied emergency funds and, later, intervened to suppress the yen. Some investors speculated that the tragedy had triggered a major policy shift and further Japanese liquidity injections would supercharge global markets already boosted by the Fed’s QE2 largesse.

These expectations seemed hopeful at the time – see previous post – and the BoJ has duly disappointed. Reserves have fallen back as lending has normalised and f/x intervention has been sterilised. As of today, they were ¥10.7 trillion ($132 billion) below the late March peak and half-way back to the pre-earthquake level – see chart. The liquidity withdrawal is boosting the yen and has probably contributed to recent commodity price weakness.

What is the UK’s non-inflationary trend rate of GDP expansion? The Office for Budget Responsibility (OBR) suggests 2.35% per annum. The Bank of England, naturally, refuses to reveal its estimate. The view here is that trend growth is below 2%, possibly 1.8-1.9%.

The OBR bases its 2.35% figure on trend productivity expansion of 2.0% and a projected rise in hours worked of 0.35%. On first inspection, the 2.0% productivity assumption looks reasonable. GDP per hour rose by 2.0% per annum between 1997 and 2008, years in which capacity utilisation in the economy was probably similar – the unemployment rate averaged 6.4% in 1997 versus 6.2% in 2008.

Measured productivity expansion over 1997-2008, however, is likely to overstate future potential, for two reasons. First, growth was artificially boosted by an outsized contribution from “financial intermediation” due to the credit boom. Financial intermediation accounts for 8% of GDP and productivity in the sector rose by 5% per annum over 1997-2008 versus an increase of 1.75% in the rest of the economy.

Financial intermediation GDP correlates with inflation-adjusted bank lending to the private sector. Output has slumped with credit since the financial crisis and – in contrast to the rest of the economy – has yet to recover, consistent with the view that part of the prior increase represented a bubble. Despite a larger cut in hours worked than in other sectors, productivity in financial intermediation is now a drag on the economy-wide trend.

A reasonable – optimistic? – expectation is that credit will revive and expand in line with overall GDP over the next 5-10 years. In that case, productivity growth in financial intermediation might converge with the rest of the economy, suggesting a trend rise in output per hour of 1.75% rather than the OBR’s 2.0%, based on experience over 1997-2008.

A second reason for doubting the OBR’s extrapolation is the recent revelation that the Office for National Statistics (ONS) underrecorded clothing inflation over 1997-2009, implying that it may have overestimated real GDP expansion. According to the Bank of England, the increase in the CPI for clothing may have been understated by 5.5 percentage points per annum, with double the impact on the RPI. With the RPI used to deflate consumption, this suggests that GDP growth was overstated by up to 0.4 percentage points, based on a 3.5% share of clothing spending.

In practice, the distortion should be smaller because the ONS calculates GDP incorporating output and income as well as expenditure data while its real GDP calculation is based partly on volume information, not only nominal inputs deflated by prices. A plausible guess is that GDP growth was overstated by 0.2-0.3 percentage points over 1997-2009, an error that will have fed into estimates of trend productivity expansion by the OBR and others.

The underrecording of clothing prices coupled with “phantom” financial-sector output gains due to the credit bubble, therefore, suggest that current trend GDP expansion is 1.8-1.9% per annum rather than the 2.35% estimated by the OBR. This would be consistent with recent evidence: unemployment has fallen slightly over the past year while survey-based measures of capacity utilisation have risen despite GDP growth of only 1.8% in the year to the first quarter, or 2.0% excluding volatile oil and gas production.

This is bad news for policy-makers. Trend expansion of 1.8% rather than 2.35% implies a GDP “pie” that is 5% smaller in 10 years’ time. Future economic expansion, in other words, may contribute less than hoped to reducing the fiscal deficit and consumer gearing. The inflation-growth trade-off, meanwhile, is likely to be less favourable than the MPC has assumed – consistent, of course, with recent experience. Interest rates may need to be raised despite “unsatisfactory” economic expansion – if the Committee wishes to adhere to its remit.

The May Inflation Report confirms that the MPC is no longer setting monetary policy in accordance with its remit.

The key measure of whether the MPC is on track to meet its target is the mean inflation forecast based on unchanged policy. The mean forecast takes account of the balance of risks around the mode or central projection – as should the MPC if it is doing its job. The mean forecast, in other words, summarises the whole fan chart*.

The Bank withholds its forecast numbers until a week after publication of the Inflation Report. This results in media attention focusing on the central projection, which is easier to estimate from the fan chart than the mean and has been significantly lower in recent Reports.

In February, the mean forecast for inflation in two years’ time assuming unchanged policy was 2.48%, representing the largest overshoot of the target since February 1998 and clearly signalling the need for higher interest rates.  Based on chart 5.13 on p.47 of the May Report, the current two-year-ahead mean forecast remains at about 2.5%. The central projection is again below the mean but has risen from 2.08% to about 2.25%. So neither measure is consistent with the 2% target.

The chart below compares the path of the mean forecast estimated from the May fan chart with the published numbers from the February Report. The forecast has been raised in every quarter until the end of 2012 – average inflation over the next two years is now 3.5% versus 3.3% in February. The MPC’s remit is 2% inflation “at all times”, not just at the two-year horizon.

A year ago, the view here was that inflation, far from heading for an undershoot as the MPC claimed, would remain above 2% for the foreseeable future, implying a need for policy tightening. The Bank now accepts this prospect but still the MPC remains inert. Many, including the Chancellor, will support the Committee’s approach but the pretence that policy is being set in accordance with “inflation targeting” should be abandoned.

*The Bank’s own advice is that “it is more appropriate to compare outturns with the MPC’s projection of the mean, rather than the mode or median”. See “Assessing the MPC’s fan charts”, Bank of England Quarterly Bulletin, Autumn 2005, p.332.