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With a further rise to 1.9% in November, annual consumer price inflation remains on course to exceed 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor. The November increase was ahead of market expectations but in line with the forecast presented in a prior note.

While commentary will focus on the role of higher fuel prices, the real story is a further pick-up in “core” inflation. Excluding energy, food, alcohol and tobacco, consumer prices rose an annual 1.9% in November, up from 1.8% in October. Had VAT not been cut last December, core inflation would probably stand at 2.7-2.8% (based on an estimate by the Office for National Statistics of the impact of the reduction).

Core inflation has exceeded Bank of England and consensus forecasts by a wide margin this year. The forecasts overestimated the disinflationary impact of rising economic slack while underestimating offsetting upward pressure from the collapse in the exchange rate. The November rise may partly reflect some retailers hiking prices ahead of the VAT reversal.

Further fuel price effects and the dropping-out of last December’s VAT cut are projected to lift headline inflation to 2.6-2.7% this month. This would yield a fourth-quarter average of 2.0%, above the 1.85% forecast in the November Inflation Report. The headline rate may reach 3.2-3.3% in January as VAT is raised before moderating later in 2010, while remaining above the 2% target – see the earlier note.

The retail price headline rate jumped from -0.8% in October to 0.3% in November, in line with the prior forecast, and is on course to reach 4% or higher by next spring. The annual rise excluding mortgage interest costs and housing depreciation climbed from 2.4% in October to 3.0% last month; the VAT reversal, energy effects and recovering house prices will push the headline rise well above this level in early 2010.

At the November Inflation Report press conference, Governor King stated that the Monetary Policy Committee intended to “look through the short-term rise in inflation” but there is a risk that sharply higher headline rates will destabilise inflationary expectations in the absence of any policy response. With fiscal plans widely judged to lack credibility, the UK can ill afford any loss of confidence in the Bank’s inflation-fighting determination.

Assuming that Bank of England purchases finish in February, the gilt market faces a six- or seven-fold increase in net supply in 2010-11. A resulting rise in yields is likely to boost pressure on an incoming government to accelerate fiscal tightening.

Revised Debt Management Office (DMO) projections issued with last week’s Pre-Budget Report show net gilt issuance – gross sales minus redemptions – of £208.5 billion in 2009-10. The Bank, however, is on course to buy £183 billion of gilts this year, based on current plans for cumulative asset purchases of £200 billion by February. The £200 billion target implies gilt-buying of £198 billion, of which £15 billion occurred in March 2009, i.e. in 2008-09.

The net supply of gilts to the market, therefore, will be only about £25 billion in 2009-10 (i.e. £208.5 billion minus £183 billion), down from £110 billion in 2008-09 and the lowest annual total since 2002-03 – see chart. This fall has contributed to the recent low level of gilt yields – 10-year yields averaged 3.6% in the first eight months of 2009-10 versus 4.2% in all of 2008-09.

Net supply to the market, however, will surge next year, barring an extension of the Bank’s buying. The Pre-Budget Report projects a fall in the central government net cash requirement (CGNCR) from £223.3 billion in 2009-10 – inflated by financial rescue costs – to £174.0 billion in 2010-11. Assuming Treasury bills and national savings contribute up to £25 billion to funding this gap (£21 billion in 2009-10), this implies net gilt supply of £149-174 billion, i.e. six to seven times this year’s £25 billion.

Combined industrial output in the Group of Seven (G7) major countries and seven large emerging economies (the “E7” – Brazil, China, India, Korea, Mexico, Russia and Taiwan) rose by 8% between February and September but fell back marginally in October – see first chart. Within the G7 there were large declines in Germany and France, partly reflecting lower car production after the end of “cash for clunkers” schemes, while among the E7 output was down in India, Russia, Korea and Taiwan, in all cases following strong gains.

The October setback was not signalled by business surveys and probably represents a pause for breath in an ongoing solid recovery. As the chart shows, a composite of the OECD’s leading indices for the G7 and E7 countries continued to rise strongly in October. G7 narrow money trends also suggest favourable near-term growth prospects – see previous post. Today’s Chinese output numbers for November were upbeat.

The recent recession and current revival in world industrial output bear a close resemblance to the deep 1974-75 contraction and subsequent recovery – see second chart and another prior post for more discussion. This comparison suggests a continuing upswing through 2010 but with growth momentum slowing as the year progresses.

US non-financial corporations’ financial surplus – the difference between their retained earnings and capital spending – rose to 1.3% of GDP in the third quarter, according to flow of funds accounts data released yesterday. Excluding the third and fourth quarters of 2005, which were distorted by a one-off repatriation of foreign profits to take advantage of temporary tax incentives, the surplus was the highest since the fourth quarter of 1960 – see first chart.

The further improvement last quarter reflected a combination of stronger profits and cuts in dividends and fixed investment, partly offset by slower destocking.

On top of this surplus, corporations raised cash from equity transactions for a second quarter, i.e. issuance exceeded share buy-backs and retirements due to cash take-overs – second chart. Bond issuance fell back from its record first-half pace but was again substantial.

Strong internal cash generation combined with capital market issuance allowed firms to increase their holdings of liquid assets and pay down short-term debt. The liquidity ratio – liquid assets divided by short-term liabilities – continued to surge, therefore, reaching its highest level since the fourth quarter of 1959 – third chart. This mirrors improvements in the Euroland and UK and supports hopes of a recovery in hiring and investment.

Some commentators have interpreted the contraction of bank lending to companies as supply-driven and likely to curtail business expansion. The flow of funds accounts suggest that bank debt repayment has been mostly voluntary, reflecting the financial surplus and fund-raising in share and bond markets. Bank loans and commercial paper outstanding fell more slowly last quarter and may stabilise and recover as destocking ends – second chart.

The yield spread of non-investment-grade corporate bonds over Treasuries is inversely related, with a lag, to the sum of the financial surplus and equity sales, expressed as a percentage of GDP. This remained historically high last quarter, suggesting scope for further spread compression – final chart.

The Pre-Budget Report announced surprisingly large medium-term fiscal tightening measures but these were necessary to prevent a further upward revision to borrowing projections. The Report takes a big political risk by raising taxes on the middle classes as well as high earners, and an economic risk by delaying a cut in borrowing until 2011-12.

Key points:

The main surprise was the 0.5 percentage point rise in National Insurance Contribution (NIC) rates from April 2011, which will hit middle earners and raise £3.0 billion by 2012-13. A further attack on pensions tax relief brings in £500 million and a freezing of the higher-rate income tax threshold £400 million in the same year. The one-off bankers’ bonus tax was overtly political rather than fiscally meaningful – it is doubtful that the projected £550 million in 2009-10 will be achieved.

The Chancellor also cut longer-term spending forecasts, with “total managed expenditure” now projected at £752 billion in 2013-14 versus £758 billion in the Budget. Savings include £3.4 billion from a one percentage point cap on pay settlements in 2011-12 and 2012-13 and £1 billion from pension reforms. The Report’s overview refers to growth in real current spending of 0.8% a year between 2011-12 and 2014-15 but this greatly underestimates the coming squeeze because it ignores plans to slash investment and a rising burden of debt interest. Detailed figures within the Report imply that total spending excluding interest will contract by a real 0.6% a year between 2010-11 and 2014-15.

Despite tax increases and reduced spending, the projection for public sector net borrowing in 2013-14 is only £1 billion lower than in the Budget, at £96 billion. With little change to underlying economic assumptions, the implication is that the Budget revenue forecasts either were too optimistic or embodied an assumption of further significant tightening.

The debt interest projections continue to be based on hopeful-looking interest rate assumptions. Net interest is forecast to rise from 1.9% of GDP in 2009-10 to 3.3% by 2014-15 but the latter figure implies an average interest rate on outstanding net debt of 4.3%, well below projected money GDP growth of 6.1% in the same year.

The Chancellor revised his projection of the fall in GDP in 2009 to 4.75% from 3.5% but maintained growth forecasts of 1.25% and 3.5% for 2010 and 2011 respectively. Despite this year’s shortfall, the money GDP projection for 2010-11 is higher than in the Budget because of faster-than-expected inflation.

By delaying deficit-cutting until 2011-12, the Chancellor is relying on the kindness of the gilt market as it takes over responsibility from the Bank of England for funding the current gargantuan shortfall. A big rise in gilt yields could yet derail his economic and fiscal strategy.

The US M2 money measure contracted over the summer, leading some commentators to expect the economic recovery to falter in late 2009, with attendant deflationary risks. Prior posts argued against this view on the grounds that the M2 decline was modest and followed strong growth, while the velocity of circulation was likely to be rising in response to miniscule interest rates and reviving risk appetite.

M2 now seems to be picking up again. It rose by 0.3% in both September and October and weekly numbers suggest a similar rise in November. Implied three-month annualised growth of about 4% is likely to be sufficient to support further solid economic expansion and could even be too strong if velocity rises by 4-5% over the next year, as an earlier post argued was possible.

Another approach to measuring monetary backing for economic growth is to add together broad money changes and mutual fund flows – the idea here is that fund flows are likely to be inversely related to the demand to hold money so provide an indirect measure of changes in velocity. As the chart shows, this indicator – the green line – has continued to expand robustly recently. (A post last week presented a similar chart for the UK.)

The concern for markets in early 2010 is not that monetary growth will be insufficient to support a sustained economic recovery but that stronger expansion and higher inflation will fully absorb the available supply, implying an absence of “excess” liquidity to push asset prices higher – in marked contrast to this year.

A recent post suggested that the surprise of the next six months would be the speed of the turnaround in labour markets. US payroll employment continued to decline in November but the fall of 11,000 was much smaller than expected while earlier months’ figures were revised up substantially.

The details of the payrolls survey were also encouraging, showing rises in weekly hours and temporary jobs – both tend to lead overall employment. The unemployment rate, based on a survey of households, retreated from 10.2% to 10.0% last month but this partly reflected a contraction of the labour force while an equivalent jobs measure from this survey was weaker than “official” payrolls.

The official series looks poised to  grow from December, judging from a jobs gauge based on the ISM manufacturing employment index, the monthly lay-off tally by Challenger, Gray and Christmas and the NFIB small firm hiring plans index – see chart.

Better labour market news will reduce worries about a “double dip” but will call time on current super-loose monetary policies, suggesting the removal of an important support for equity markets and other “risky” assets in early 2010.

GDP can be measured in three ways, by summing output, expenditure or income across the economy. The Office for National Statistics (ONS) relies on output information for early estimates of GDP growth, with expenditure and income data incorporated during the subsequent revision process.

The fall in GDP in the third quarter was last week revised from 0.4% to 0.3%. Many economists expect a further upgrade as the ONS improves its measurement of output and incorporates more information on expenditure and income. These hopes, however, are not supported by early data based on the alternative approaches.

Separate output, expenditure and income measures of GDP can be calculated from background information supplied by the ONS. The output measure fell by 0.3% last quarter – the basis for the published GDP drop – but the expenditure and income measures registered larger declines of 0.5% and 0.9% respectively. (These figures refer to “unaligned” estimates excluding adjustments to reduce discrepancies between the three approaches.)

The chart shows published GDP at constant market prices, indexed to calendar 2005, together with the three underlying measures. In level terms, the expenditure measure was in line with published GDP last quarter but the output and income measures were lower. A simple average of the three was 0.2% below published GDP. This indicates that the published measure already incorporates an assumption of future upward revisions to underlying data.

The chart also reveals a disagreement between the three measures about the start-date of the recession, with output – and published – GDP peaking in the first quarter of last year but the expenditure and income measures one quarter later.

Recent sluggish broad money growth in the US and UK is unlikely to signal economic weakness since investors are voluntarily shifting out of cash in response to low interest rates and perceived opportunities in markets. Reduced money demand releases additional liquidity to support economic expansion.

In further evidence of this shift, UK retail buying of mutual funds (unit trusts and OEICs) was again solid at £2.4 billion in October, according to Investment Management Association figures. Inflows are on course to exceed £25 billion for the year as a whole, well above the previous annual record of £17.7 billion in 2000.

The chart shows six-month growth in “M4 excluding other financial corporations” – i.e. money holdings of households and non-financial firms – together with a six-month running total of retail mutual fund flows, expressed as a percentage of the M4 measure. Fund buying has been on a similar scale to the rise in the money supply recently.

In the current context, the sum of money growth and mutual fund flows is probably a better guide to liquidity support for the economy than M4 itself. This indicator – the green line in the chart – bottomed in late 2008 and recovered significantly during the first half, with faster expansion maintained recently. This supports hopes of an imminent economic pick-up. (See previous post for a similar US analysis.)

The Bank of England this week revealed that it provided covert “emergency liquidity assistance” (ELA) to RBS and HBOS between 1 October 2008 and 16 January 2009, with the combined loan peaking at £61.6 billion on 17 October 2008. Why were analysts unable to uncover this operation from the Bank’s weekly balance sheet, the “Bank return”?

The RBS / HBOS loans, like the earlier Northern Rock facility, were probably recorded under “other assets” on the Bank return. “Other assets” were on a declining path from early 2008, reflecting the repayment and eventual transfer to the Treasury of the Rock loan. They surged, however, after Lehman’s failure, rising from a low of £21 billion on 10 September 2008 to a peak of £170 billion on 22 October. It now appears that about £60 billion of this increase was due to the RBS / HBOS loans.

The problem for analysts at the time was that “other assets” were simultaneously being boosted by US dollar repo operations, involving the Bank borrowing from the Federal Reserve under a swap arrangement and lending on to banks short of dollar funding. These operations began on 18 September 2008 and rose to a peak around the same time as the RBS / HBOS loans.

While it was possible to track the Bank’s dollar lending to the market, the swap facility could, in theory, have involved the Bank holding additional dollar cash in a reserve account at the Fed. This would also have been included within “other assets”. So although the dollar loans were smaller than the rise in “other assets”, it would have been a leap to conclude that the Bank was engaging in additional covert lending.

The hypothesis that the surge in “other assets” was due to the swap arrangement was seemingly supported by a similar change in “other liabilities” on the Bank return – these would have included the borrowing from the Fed and rose from £16 billion to £158 billion between 10 September and 22 October 2008. In fact, part of this increase was probably also connected with the RBS / HBOS support. In particular, “other liabilities” may have included a loan from the Treasury / Debt Management Office (DMO) to the Bank to finance the ELA operation, with the DMO funding the loan via debt sales.

“Other assets” stood at £192 billion last week (18 November) but now include a loan of £180 billion (19 November) to the asset purchase facility (APF). In other words, without the APF “other assets” would have fallen back to £12 billion – the level in early September 2007, just before Northern Rock imploded.