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The rise in CPI inflation to 3.7% in December and 4.0% in January was in line with a suggested profile prepared after release of the November number, although there were small differences in the detail. The chart shows an updated forecast based on the following assumptions:

• Unprocessed food inflation rises further to a peak of 7% in March before moderating to 3.5% by year-end.

• Energy prices trend gradually higher, with a 2.5% rise over the next 12 months.

• “Core” inflation – excluding energy and unprocessed food – runs at 2.25-2.5% annualised, in line with an estimate of the trend leading into the recent VAT hike.

On this basis, the headline CPI rate is projected to reach 4.4% in February, returning to this level in September before subsiding to 2.5% in early 2012 as the VAT effect drops out.

The core assumption underlying this forecast is conservative: rising inflation expectations and eroding spare capacity could lead to a firmer core trend moving into 2012.

In his latest explanatory letter, Bank of England Governor Mervyn King states that “The MPC’s central judgement, under the assumption that Bank Rate increases in line with market expectations, remains that, as the temporary effects of the factors listed above wane, inflation will fall back so that it is about as likely to be above the target as below it two to three years ahead.”

Despite the “remains”, this appears to represent a hawkish shift relative to the November Inflation Report, which judged that inflation was more likely to be below 2% (probability of 56%) at the two-year horizon on the basis of less aggressive market expectations than currently. If confirmed tomorrow, the implication is that the MPC is endorsing the market’s view of three quarter-point rate hikes during the course of 2011.

A post in November suggested that emerging equity markets were losing their lustre, with anti-inflation policies likely to slow growth in 2011 and valuations looking ambitious relative to developed markets.

Prices are bouncing today but, as of Friday’s close, emerging markets had lost 5.1% year-to-date in US dollar terms versus a 5.0% gain for developed markets (MSCI return indices). The recent setback has wiped out outperformance since September 2009 – see first chart.

Three of the four BRIC markets look in trouble. Chinese and Indian three-month market rates have risen by 200 basis points (bp) since November. A sharp deterioration in China’s trade balance in January partly reflected holiday distortions but a surge in imports is consistent with overheating – second chart. Indian banks’ three-month funding costs are now more than 100 bp higher than the 10-year government bond yield, implying restrictive policy. In Brazil, real narrow money, M1, has contracted over the last six months. Russian monetary conditions are loose currently but inflation is picking up strongly.

Six-month growth in E7 industrial output strengthened in late 2010, as did a composite leading index derived from the OECD’s country indices. A “double-lead” indicator based on the short-term momentum of the leading index, however, weakened in November and December, signalling a peak and slowdown in output momentum this spring – third chart. With a likely further rise in inflation precluding policy loosening, markets may fret about an economic “hard landing” later in 2011 and 2012.

The US Treasury’s decision to reduce its “supplementary financing program” (SFP), under which it issues additional bills and places the proceeds on deposit at the Federal Reserve, will result in a large increase in bank reserves and the monetary base over coming weeks, on top of the impact of the Fed’s continuing securities purchases.

The SFP is being run down to delay the national debt hitting the current authorised ceiling of $14.29 trillion, which Congressional Republicans are resisting increasing. Even with this initiative, debt is expected to reach the limit by mid-May at the latest. The Treasury has announced that the SFP will decline from $200 billion to $5 billion. A reduction to $175 billion occurred over the last week.

The $195 billion planned decline will feed directly into bank reserves and the monetary base (i.e. reserves plus currency in circulation) as the Treasury repays bills by running down the balance in its Fed account.

As previously noted, the Fed is on track with its plan to buy a net $600 billion of securities by mid-2011 but the increase in bank reserves has so far fallen short of purchases – see chart. This seems to reflect exogenous factors (such as a repayment of Fed credit by AIG) though could hint that officials are becoming concerned about overstimulating the economy.

The SFP run-down, however, is likely to push bank reserves and the monetary base above the QE2-implied path. Assuming that the SFP falls to $5 billion as planned, and continuing Fed securities purchases are unsterilised, reserves may reach about $1.46 trillion by the start of April – $470 billion or 48% more than when QE2 was announced in early November. Completion of the QE2 programme would imply a rise to about $1.68 trillion by mid-year – equivalent to 11% of annual GDP.

A further liquidity injection could sustain increases in commodity prices, fuelling bond market inflation worries. With the US economy apparently performing strongly in early 2011, the Fed may soon come under pressure to scale back QE2 or sterilise the impact, for example by auctioning term deposits.

Last week’s solid purchasing managers’ surveys for January supported the scepticism expressed in a previous post about the official assessment that underlying GDP performance (i.e. after adjusting for the impact of bad weather in December) was “flattish” in the fourth quarter.

Further evidence that the economy is still expanding is provided by the Monster employment index, which tallies vacancies posted on job boards (not just monster.co.uk) and corporate career sites. After adjusting for seasonal variation, the index rose sharply in January, reaching its highest level since November 2008. This confirms the message of the Reed job index released last week. (The Reed index covers only opportunities posted on reed.co.uk and has a shorter history than the Monster survey.)

The Monster index tracks or leads the official vacancies series – see chart. Vacancies are a coincident indicator of GDP and lead employment. The January increase, therefore, suggests that GDP is growing solidly in early 2011 while employee numbers will rise over coming months, reversing a small decline in late 2010.

Consensus pessimism about labour market prospects partly reflects worries about public-sector job losses but these are scheduled to be staggered over several years. Of a 330,000 fall in general government employment between 2010-11 and 2014-15, the Office for Budget Responsibility projects only 40,000 to occur by March 2012.



US capital goods manufacturers are increasingly bullish about their domestic sales prospects, according to a report in today’s Financial Times. This accords with the ISM’s December semi-annual investment intentions survey, indicating that manufacturing firms planned a 15% increase in capital spending in 2011, the largest since 1998 – see first chart.

Labour demand typically follows investment. January’s jobs gain was depressed by bad weather but business surveys suggest that private payrolls expansion should strengthen significantly – second chart. Online job advertisements surged in January, as noted in a post last week.

A return of corporate “animal spirits” is also evidenced by a recent revival in bank credit demand. Commercial and industrial loans are still down by 5% from a year ago but have risen since the autumn, with the Federal Reserve’s latest senior lending officer survey pointing to a further pick-up – third chart.

Rising corporate credit needs are clashing with a widening federal deficit, contributing to upward pressure on bond yields, despite the Fed’s QE2 programme. (The Congressional Budget Office projects a rise in the deficit to 9.8% of GDP in fiscal 2011 from 8.9% last year.) A resumption of C&I loan growth in 1994 coincided with a severe Treasury bear market – the final chart draws an ominous comparison with recent yield movements.

Yesterday’s post suggested that UK rates will rise soon. It would be unusual for the MPC to tighten policy when the Federal Reserve is still loosening, via its QE2 securities purchases. Will the Fed’s stance also shift over coming months?

The first chart shows US official interest rates together with a leading indicator of Fed policy based on trends in unemployment and core inflation and a measure of supply bottlenecks from the ISM manufacturing survey. The indicator is constructed so that a positive reading signals a need for tighter policy and vice versa. (The Fed has stated a target for the Fed funds rate since 1995; the discount rate is used as the official measure for earlier years.)

The indicator turned negative in June 2007, three months before the first Fed rate cut and six months before the onset of the recession. It continued to weaken during 2008 and early 2009, reaching a trough in May before embarking on a sustained recovery. Since mid 2010 the indicator has been hovering just below zero.

Of the components, the ISM bottlenecks measure is already positive. Labour market leading indicators, meanwhile, suggest that the unemployment component will move above zero during the first half of 2011. Core inflation, therefore, may need to fall further to keep the indicator in negative territory. Core CPI trends, however, may deteriorate, with goods inflation boosted by pass-through of cost increases and the important housing rents component firming in response to a falling rental vacancy rate.

So the Fed leading indicator could turn positive as early as this spring, suggesting an increase in official rates in the late summer.

The second chart shows how the Fed is progressing with its plan, announced in November, to buy a net $600 billion of securities by mid-2011. While the purchase programme is on track, the impact on bank reserves and the monetary base has been smaller than expected, implying partial sterilisation. This could indicate that the Fed is already concerned about overstimulating the economy; there is an outside chance that it will end QE2 early in the event of strong data over the next couple of months.

The February MPC vote is on a knife-edge, according to an “MPC-ometer” model designed to predict policy decisions based on incoming economic and financial information. The model suggests a 4-4-1 split (i.e. four votes to hike offset by Adam Posen’s call for more QE), leaving the hawks just short of majority.

The MPC-ometer foresaw support for long-standing hawk Andrew Sentance at the January meeting – see previous post. Spencer Dale and Paul Tucker are plausible additions to the Sentance-Weale axis this month.

Most economists assume that a rate hike is still distant following news of a 0.5% fall in GDP in the fourth quarter and a defiantly-dovish speech by Bank of England Governor Mervyn King. The median forecast is for a quarter-point rise in the fourth quarter of 2011, according to the monthly Reuters poll.

The MPC is likely to discount the snow-affected headline GDP result but place weight on the ONS assessment of a “flattish” underlying performance – still notably weaker than expected. The MPC-ometer, however, judges that this negative surprise will be more than offset by a further surge in consumer and business price expectations in January as well as solid survey activity indicators and strong financial markets.

Analysts may have been bamboozled by Mr King’s speech, which is not necessarily reflective of the balance of opinion on the Committee.

If the model forecast is correct, the hawkish camp will be well-positioned for a rematch in March, possibly armed with further data suggesting a strong GDP bounce-back in the first quarter.

UK money supply figures for December are a mixed bag, suggesting moderate economic expansion during the first half of 2011.

Encouragingly, corporate liquidity has improved further, with non-financial corporations’ sterling and foreign currency deposits rising at a 4.3% annualised rate in the three months to December. Echoing business surveys, strength was focused on the manufacturing sector, with a stunning 22.1% rise, while deposits of companies in the services sector slipped by 1.4%.

With companies continuing to repay debt, the liquidity ratio (i.e. bank deposits divided by bank borrowing) reached its highest level since the second quarter of 2007. Excluding the overleveraged commercial property sector, the ratio is at a new high in data extending back to 1998 – see chart. The liquidity ratio leads business investment, which rose by 8.9% in the year to the third quarter.

Broad money rose by 3.0% annualised in the three months to December while annual growth moved up to 2.3%. As previously argued, a 2-3% rate of increase may be more than sufficient to support trend economic expansion and 2% inflation because the velocity of circulation is rising in response to negative real interest rates. Some MPC members seem to be placing less weight on low broad money expansion as a factor restraining inflation, with the January minutes stating that “money and credit growth could remain weaker than nominal spending growth for some while”.

There are two concerns. First, narrow money remains sluggish – M1, on the ECB’s definition (i.e. currency plus overnight deposits), rose by only 1.3% in the 12 months to December, unchanged from November but down from 5.0% in December 2009. A further fall would be alarming. Secondly, high inflation is acting as a drag on economic prospects by weakening real-terms monetary trends. This, however, argues for the MPC to press ahead with policy tightening to prevent the current inflation overshoot from becoming entrenched.

In further evidence that US companies have shifted into expansionary mode, online job postings rose sharply in January, having moved sideways during the second half of 2010, according to the Conference Board. Vacancies lead employment, suggesting stronger payrolls growth ahead – see chart. Confidence in this prospect will increase if the pick-up in postings is confirmed by the Monster employment survey, released on Thursday.