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The further upward revision to fourth-quarter GDP growth to 0.4% from an originally-reported 0.1% brings the official series into line with earlier expectations. The initial 0.1% estimate, released in late January, probably influenced the MPC members who considered expanding gilt-buying at the February meeting.

The revised figures also confirm that the fall in non-North Sea output in the recent recession was smaller than during the 1979-81 contraction. Gross value added (GVA) excluding oil and gas declined by 5.8% between the first quarter of 2008 and third quarter of 2009 versus a 6.4% drop between the second quarter of 1979 and first quarter of 1981 – see chart.

On top of the fourth-quarter upgrade, the fall in GVA excluding oil and gas in the third quarter was lowered from 0.2% to 0.1% (0.08% to two decimal places). Further revisions may show that the non-oil economy bottomed in the second rather than third quarter, as suggested by business surveys and labour market evidence.

The economic polling model discussed in prior posts suggested that the Conservative lead over Labour would fall into hung parliament territory in early 2010 but rewiden in the spring, mainly reflecting the negative impact on government popularity of a sharp increase in retail price inflation. Recent polls, showing a Tory fightback, are consistent with this “forecast”.

The model uses ICM polling data, which extends back to the early 1980s. (ICM is well-regarded, having scored a notable success at the 1997 election.) Based on recent economic data and a forecast further rise in inflation to 4.5% by April, the model suggested a Conservative / Labour lead of seven percentage points in March, rising to nine in April and 11-12 in May – probably sufficient to produce a Conservative majority.

The latest ICM poll, published in the News of the World on Sunday, reported an eight point gap, up from six points a fortnight earlier.

The suggestion that the economy is turning less favourable for Labour is supported by the EU Commission consumer survey for March, showing a fall in the composite confidence indicator to -5 from -2 in February – a four-year high. This may reflect the impact of higher inflation on spending power – the net percentage of consumers reporting higher prices over the last 12 months rose to 18 in March, up from a low of 7 in November and above the average of 12 since 1990.

The ECB has increased its backdoor support for Greece during the recent crisis, according to Bank of Greece statistics. Lending by the central bank to the domestic banking system rose by €12.5 billion in February to a record €59.8 billion – see first chart. Banks used the cash partly to buy an additional €2.7 billion of Greek government bonds and cover a €3.3 billion withdrawal by domestic private depositors.

A key component of the Greek rescue plan agreed yesterday was the confirmation by ECB President Trichet that the central bank will continue to accept collateral rated down to BBB- in its lending operations beyond year-end. This represents a defeat for Bundesbank-led ECB hawks who wanted to return the minimum rating to its pre-crisis level of A-, thereby cutting Greece adrift in the event of Moody’s downgrading its rating to match S&P and Fitch, both at BBB+.

The success of the plan may hinge on whether it stems the incipient run on Greek banks. Private deposits have fallen by €8.4 billion, or 3.5%, since December as EMU exit worries have mounted – second chart. The Bundesbankers may have been forced to agree to keep Greece’s life support switched on in return for IMF participation in the rescue deal but could baulk if backdoor lending continues to balloon.

The Budget was low-key and does not meet its aim of placing the UK on a “credible path of fiscal consolidation”. The projected fall in borrowing over the medium term continues to rest on optimistic economic and financial assumptions and an absence of detail about future spending cuts.

The Chancellor has been able to create the illusion of fiscal progress by revising up excessively-pessimistic revenue projections presented in the April 2009 Budget and carried over to December’s Pre-Budget Report (PBR). Net taxes and national insurance contributions are now forecast at 33.9% of GDP in 2009-10 versus 33.2% in the PBR. This explains the cut in public net borrowing from 12.6% of GDP to 11.8%.

The revenue “windfall” carries over to future years, accounting for the cut in the 2014-15 borrowing projection from 4.4% of GDP in the PBR to 4.0%.

Projections for spending, by contrast, are little changed. Total managed expenditure (TME) is forecast to fall from 47.9% of GDP in 2009-10 to 42.3% in 2014-15. The 5.6 percentage point decline over five years is ambitious but not unachievable – TME fell from 47.8% of GDP to 38.9% between 1983-84 and 1988-89. The Chancellor, however, provided no new information on the departmental distribution of cuts. Capital spending will be a major casualty, falling from 4.9% of GDP in 2009-10 to 2.6% by 2014-15, at odds with the claim that the Budget is designed to support investment.

The forecasts for debt interest continue to look optimistic. Net interest is projected to rise from 1.9% of GDP in 2009-10 to 3.3% by 2014-15. The latter figure, however, implies an average interest rate on net debt of only 4.4%, effectively assuming away any future funding difficulties. Each one percentage point rise in the average interest cost would boost the 2014-15 net interest bill by 0.7% of GDP.

The various Budget measures were designed to attract headlines but are insignificant in macroeconomic terms. A net “giveaway” of £1.4 billion in 2010-11 is offset by tax changes yielding £150 million and £705 million in 2011-12 and 2012-13.

The Debt Management Office projects that net gilt sales (i.e. gross sales minus redemptions) will fall from £211 billion in 2009-10 to £148 billion in 2010-11 – a smaller decline than expected, reflecting a cut in Treasury bill financing from £19 billion to -£2 billion. Assuming no further Bank of England buying, the supply of gilts to be absorbed by the market will rise from £28 billion this year to the full £148 billion in 2010-11 – well above the previous record of £110 billion in 2008-09.

Consumer price inflation fell from an annual 3.5% in January to 3.0% in February but this is unlikely to mark the beginning of a sustained decline to about 1% by early 2011, as forecast by the Bank of England in the February Inflation Report.

A return to 3% was predicted in a post last month and reflected a fall in food and energy inflation together with a large monthly rise in “core” prices in February 2009 dropping out of the annual comparison. A further decline, however, is unlikely near term: monthly core price increases were low over March-June 2009 while energy inflation should rebound as a result of higher petrol prices and cuts in household bills last spring falling out of the calculation.

Assuming no significant impact from Budget decisions, CPI inflation is projected to fluctuate in a 3.0-3.25% range until mid-year before declining modestly during the second half, remaining well above the 2% target.

Services inflation has exerted downward pressure on the headline rate over the past year, falling from an annual 4.6% in December 2008 to 3.0% in February. The decline, however, may be coming to an end as the economy recovers: the balance of consumer services companies planning to raise prices has increased sharply, according to the first-quarter CBI / Grant Thornton survey released earlier this month – see first chart.

Goods inflation excluding food and energy, meanwhile, eased from an annual 3.3% to 2.6% in February but will be underpinned by recent exchange rate weakness and pass-through of surging raw material costs – sterling commodity prices, as measured by the Journal of Commerce industrials index, are two-thirds higher than a year ago. The balance of CBI manufacturing firms planning to hike prices rose to an 18-month high in March and is above its long-run average – second chart.

The February headline rate of 3.0% compares with the Bank of England’s forecast a year ago that inflation would average 1.3% in the first quarter of 2010. The Bank has failed to provide a coherent explanation for its forecasting miss and markets appear to be increasingly sceptical of its inflation-fighting commitment, judging from a widening yield gap between conventional and index-linked gilts – third chart.

The Federal Reserve this week reiterated its assessment that “economic conditions … are likely to warrant exceptionally low levels of the federal funds rate for an extended period”. While official rates will stay low, however, the Fed has already begun to withdraw liquidity from the banking system.

The monetary base – currency plus bank reserves at the Fed – has fallen for three consecutive weeks, by a cumulative 4.7%. This mainly reflects the impact of the “supplementary financing programme” (SFP) under which the Treasury issues bills and deposits the proceeds at the Fed – this has more than offset a further liquidity injection from central bank purchases of mortgage-backed securities (MBS).

Monetary base movements have recently led equity market fluctuations – see Andy Kessler’s Wall Street Journal article and the chart below.

The Fed will complete its $1.25 trillion of MBS purchases by the end of the month but carried $1.066 trillion on its balance sheet as of Wednesday, suggesting a further substantial liquidity injection. The SFP, however, is scheduled to rise from $75 billion to $200 billion. The net impact of these and other changes on the monetary base is uncertain; a further decline would be another warning signal for markets.

The Dow Jones industrial average fell by 54% from peak to trough in the bear market between October 2007 and March 2009. The Dow has declined by 45% or more on seven prior occasions since 1900 – see table. Six of these declines were in the 45-55% range, the exception being the depression bear market of 1929-32, when prices dropped by 89%.

The Dow reached its low on 9 March 2009 and had risen by 61% by 9 March 2010. This is in the middle of the 42-85% range of first-year recoveries after the six prior big bear markets, excluding the 1929-32 decline. The mean rise across these recoveries was 59%.

The Dow’s performance was mixed in the second year after the troughs of these prior cycles. The change in prices ranged from a fall of 8% to a rise of 22%, with a mean increase of 7%. In one case – the recovery after the 1973-74 bear – a strong second-year gain followed a below-average rise in the first year.

Historical evidence, therefore, suggests that equity markets are entering a less dynamic period, although any downside risk should be modest against the background of a continuing economic recovery. This conclusion is consistent with evidence of less favourable global liquidity conditions discussed in yesterday’s post.

The liquidity “jaws” are closing. Annual growth in Group of Seven (G7) real narrow money, M1, was only marginally higher than industrial output expansion in January – see first chart. The series are likely to have crossed in February, with the annual output gain boosted by a large monthly decline in February 2009 falling out of the calculation.

Since 1970, global equities on average have underperfomed cash by 5% per annum when annual real M1 growth has fallen short of output expansion while outperforming by 11% pa at other times – see previous post. These averages, of course, conceal significant variation but the ex ante return / risk profile of holding equities has deteriorated.

Slower real money growth than output expansion implies that the economy is draining liquidity from markets. Historically, cross-overs have also signalled higher short-term interest rates. On average, G7 short rates have risen by 0.7 percentage points per annum during real money / output growth shortfalls while falling by 0.9 points pa at other times – second chart.

G7 plus E7 industrial output continues to rise solidly and is now only 4% below its pre-recession peak – see prior post – while the recovery is broadening to labour markets. Central bank policies adopted during the financial emergency – suppressing official interest rates below inflation and flooding banking systems with reserves – are increasingly misaligned with economic developments.

The Federal Reserve last night repeated its commitment to low interest rates for an “extended” period but this does not preclude an early withdrawal of liquidity. A rise in Chinese official rates is overdue while the UK “MPC-ometer” is close to signalling a need for policy restriction. Earlier-than-expected monetary tightening could be the trigger for a set-back in equity markets.

Prior posts have argued that weak broad money trends in the US and Europe are not an obstacle to a continuing economic recovery because corporate liquidity is rising solidly, supporting prospects for business investment and hiring. Firms have been able to raise cash levels because of a fall in the demand to hold money by households and financial institutions, mainly reflecting negative real interest rates.

This hypothesis received further support from US fourth-quarter flow of funds accounts data released last week. A broad money measure comprising currency, banking system deposits, money market mutual funds, repurchase agreements and foreign deposits was unchanged in the year to end-December but this stability concealed a rise of 8.5% in business holdings offset by falls of 1.9% and 3.0% respectively in household and financial money – see first chart. Business liquidity grew at a 15.0% annualised rate during the second half.

The decline in household and financial money implies that there is less “sideline cash” available to flow into markets and push up prices. Expressed as a proportion of financial assets, however, money holdings are still at a “normal” level by recent historical standards – second chart. Investors may wish to rebalance their portfolios further away from cash in response to the negative real interest rate “tax” imposed by central banks.

Combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (the “E7”, defined here to include Brazil, China, India, Russia, Korea, Taiwan and Mexico) rose by a further 0.8% in January to stand 10.9% above its trough reached in February 2009. Following a 13.6% drop during the recession, output is now only 4.2% below the peak reached in February 2008.

The recovery has been led by the E7 – output has risen by 19.1% from a low in January last year and is 8.8% above its pre-recession peak. G7 production, by contrast, has recovered by 8.3% from a March 2009 trough and is still 12.9% below peak. Relative performance improved in January, however, with a 1.4% gain versus flat E7 output, reflecting a sharp fall in Russia.

The recession and recovery in G7 plus E7 output continues to track closely G7 performance during and after the mid 1970s first oil shock downturn. This template suggests a sustained economic upswing but with momentum slowing during the second half of 2010 and into 2011 – see first chart.

The interpretation here is that recent monetary developments are consistent with this template. G7 real broad money is contracting on an annual basis but this is unlikely to signal insufficient liquidity to support an ongoing economic recovery because of a fall in household and institutional money demand due to negative real interest rates. Corporate liquidity – a key driver of the business cycle – continues to improve while narrow money M1 is rising solidly. Real M1 expansion, however, has moderated, suggesting slower economic growth later in 2010 – second chart.