Economists project US annual average inflation of 2.3% over the next 10 years, according to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. Assuming that this is representative of wider market expectations, the current 10-year Treasury yield of 3.4% implies a real interest rate of only 1.1%.

The first chart shows a long-term history of this real yield measure (i.e. the 10-year Treasury rate minus economists' 10-year inflation forecast)*. The current 1.1% compares with a median real yield since 1953 of 2.6%. This suggests that the nominal 10-year yield would need to rise from the current 3.4% to 4.9% to represent "fair value" by historical standards, assuming no change in inflation expectations.

Such an increase is unlikely to be triggered by the end of QE2, which is fully discounted. A more probable source of upward pressure is a strengthening of corporate credit demand as economic recovery continues, resulting in a clash with government financing needs. Growth in corporate credit market debt outstanding rose from 4.5% to 5.5% annualised between the first and second halves of 2010, according to the flow of funds accounts.

While overall borrowing firmed, companies continued to repay bank credit during the second half. This has changed in early 2011, with banks' commercial and industrial loans rising at a 6.3% annualised pace in the first three months and by 11.3% in March alone – second chart. Stronger credit demand alongside increased hiring and M&A is evidence of a return of corporate "animal spirits", in turn suggesting rising risks for Treasuries.

* The 10-year inflation forecast in the Survey of Professional Forecasters starts in 1991. An equivalent measure from The Blue Chip Economic Indicators survey was used over 1979-91. For earlier years, expectations were proxied as a function of actual inflation.

A useful summary measure of whether the MPC is on track to meet the 2% inflation target is the Bank of England's mean projection two years ahead based on unchanged policy. In the February Inflation Report, this stood at 2.48%, representing the largest positive deviation from the target since February 1998 and clearly signalling the need for higher interest rates – see chart.

MPC doves, led by the Bank's Governor Mervyn King, have used two subterfuges to deflect media and market attention away from this glaring inconsistency. The first is to refer to the central or modal projection rather than the mean forecast. The central projection two years ahead assuming unchanged policy was 2.08% in February. The mean forecast also takes account of the skew of risks – judged to be weighted strongly to the upside currently. The inflation-targeting remit implies that the MPC should be equally concerned about over- and undershoots and it is reasonable to place greater weight on avoiding large deviations, in which case the mean forecast is the correct focus of policy.

The second trick is to refer to the forecast based on market interest rate expectations rather than unchanged policy. This allows the doves to take credit for market-implied tightening without ever delivering. In February, for example, the central and mean forecasts two years ahead incorporating the market interest rate path were 1.62% and 2.02% respectively. This, however, assumed an average Bank rate of 0.7% in the second quarter, implying a quarter-point rate hike in April or May – most economists expect continued inaction next month. In this way, the MPC can repeatedly push back the start date of tightening while claiming that policy is still consistent with the target, based on later significant interest rate rises discounted by the money market curve.

Also convenient for the Governor's "news management" is the convention of releasing the forecast numbers a week after publication of the Inflation Report. The central projection is more readily estimated from the Report's fan charts than the risk-adjusted mean. Journalists at the February press conference struggling to absorb a large volume of information understandably failed to spot the large overshoot of the mean forecast, enabling the Governor to escape difficult questioning on how this could be reconciled with unchanged policy. The caravan had moved on by the time the numbers barked a week later.

While these presentational tricks provide useful wriggle room, the doves can, of course, simply enforce a change in the forecast to suit their policy prescription, since the forecasting process is almost completely opaque and reliant on "judgement". The two-year-ahead projection, for example, was cut between May and August last year without credible justification as the doves sought to lay the foundation for a further expansion of QE, following the US lead given by their soul-mate Professor Bernanke. Reality – in the form of much higher inflation than the August Report projected – intervened to stymie these plans.

Will such an ad hoc downward adjustment be used to justify a further delay in raising rates at the May MPC meeting? As of yesterday, sterling's effective rate was 1.5% below the starting level assumed in the February Inflation Report while energy prices were significantly higher, factors arguing for an upward inflation revision. The doves, however, may resort to their favoured if tarnished "output gap" defence if next week's preliminary GDP release shows a smaller first-quarter rise than the 0.6-1.0% apparently factored into the February forecast (although business surveys and labour market trends suggest that official output statistics understate recent economic performance).

The opacity of the forecasting process and scope for creative interpretation of the remit and presentational manipulation imply that there is no effective constraint on the MPC's "discretion". Inflation-targeting has become meaningless.

Equities have lost traction recently, probably reflecting a less favourable monetary backdrop and consistent with behaviour at the equivalent stage of prior recoveries after large bear markets – see previous post. Credit markets also suggest a decline in risk appetite, with Euroland, corporate and emerging market yield spreads widening – see first chart.

Risk assets will continue to receive support from the Federal Reserve's liquidity injections. As of last Wednesday, the Fed's securities portfolio had expanded $400 billion from its level in early November when the $600 billion "QE2" programme was announced. Assuming no sterilisation, therefore, bank reserves at the Fed are on course to rise by a further $200 billion to $1.73 trillion by mid-year, equivalent to 11.5% of GDP versus a previous record (in 1940) of 6.9% – see second chart and earlier post.

Market strength in late March and early April, however, also reflected a surge in Japanese bank reserves following the 11 March tragedy, due to foreign exchange intervention to hold down the yen and an increase in Bank of Japan lending to stabilise the financial system – second chart. Reserves have fallen by $70 billion from the recent peak and may continue to decline if the central bank allows the lending rise to reverse as economic and financial conditions normalise. A return to the 11 March level would imply a further $200 billion drop.

The Bank of Japan, in other words, could neutralise the impact of the Fed's remaining liquidity injection unless it acts to sustain bank reserves at their recent higher level. The central bank, however, has announced only a modest expansion of asset purchases since the tragedy and is reluctant to target reserves, viewing such an approach as a throwback to the failed QE policy of 2001-06. Renewed yen strength may be necessary to force a more expansive stance.


The Chinese economy remained hot in early 2011 but monetary trends are signalling an imminent slowdown.  With the “output gap” positive, however, growth must be held below trend for several quarters to relieve inflationary pressures and allow the monetary authorities to ease off on the brakes. Near term, Chinese equities may face the unappealing combination of earnings downgrades with no monetary loosening.

GDP grew by 9.7% in the first quarter from a year before and by 2.1%, or 8.8% annualised, from the fourth quarter of 2010. Domestic demand was up by 10.2% from a year ago but trade subtracted 0.5 percentage points from GDP growth as imports boomed – consistent with the economy "overheating".

The first chart shows six-month growth of industrial output and real money. Recent output buoyancy reflects both stronger global demand and a mini-revival in monetary expansion during the second half of last year. Policy tightening and higher inflation, however, have caused real money trends to weaken in early 2011. With global momentum peaking, the economy could slow sharply over coming months.

Will slower growth bring early inflation relief, heading off further monetary policy tightening? Probably not. The scale of monetary excess over 2008-10 and an associated positive "output gap" – second chart – suggest that inflationary pressures will remain strong for some time after the economy starts to cool. Today's inflation news was poor, with headline and non-food CPI inflation rising to 5.4% and 2.7% respectively in March and the more realistic GDP deflator climbing by an annual 7.6% in the first quarter – third chart.

The Labour Force Survey employment measure reached a new recovery high in the three months to February, reflecting increased employee numbers despite public sector job cuts – see first chart.

The LFS measure could stabilise or fall back slightly near term, based on recent slippage in vacancies – first chart. The Monster index of online job postings, however, suggests that labour demand is holding up – second chart.

Reflecting the employment rise, LFS unemployment fell to 2.48 million, the lowest since September. The more timely claimant-count measure was down further in the latest three months, though was boosted in March by a change in eligibility for single-parent benefits, resulting in an increase in applications for job-seekers' allowance – third chart.

Total hours worked have outpaced employment as the length of the average work-week has recovered. Hours worked correlate with GDP, suggesting that economic recovery remains on track despite recent weather-related volatility – fourth chart.

Judging from media reports, today's data releases represent a triple jackpot for interest rate doves – inflation down, house prices weakening and retail sales slumping. Closer examination, however, suggests otherwise.

The most significant news, arguably, was a further narrowing of the trade deficit in February, reflecting stronger export volumes and a fall in imports – see first chart. Based on the January / February results, trade is on course to boost first-quarter GDP growth by 1.25-1.5 percentage points – further evidence that the economy has bounced back solidly in early 2011 despite high-street weakness (although the Visa Europe expenditure index released last week suggests that consumer spending rose last quarter).

The fall in CPI inflation from 4.4% in February to 4.0% in March was mainly due to a slowdown in food prices and air fares. This effect is likely to prove temporary: it may partly reflect Easter falling later this year than last while food commodity prices and fuel costs have climbed further in recent weeks – second chart.

In addition to the March inflation figures, the Office for National Statistics released an analysis of the impact of the rise in the standard VAT rate from 17.5% to 20%. The increase is estimated to have boosted annual CPI inflation by 0.76 percentage points in January, implying that the headline rate would have been 3.2% rather than 4.0% in its absence. This blows apart the claim that inflation would be close to the target but for the VAT hike, based on the misleading "CPI at constant tax rates" measure, which assumes that tax changes are passed on in full (CPI-CT rose an annual 2.3% in January and 2.4% in March).

The value of retail sales dropped by 1.9% in March from a year before, according to the British Retail Consortium, but weakness largely reflected the Easter effect, a point naturally downplayed by the organisation's propagandists. This is demonstrated by comparing sales with 2009, when Easter Sunday fell on 11 April (4 April in 2010): the average of the current and year-before annual changes was 2.35% in March, within the recent range and well above lows in late 2008 / early 2009 – third chart.

The 1.5% February decline in the Department of Communities and Local Government house price index, meanwhile, was entirely seasonal – the loss represents the smallest February fall since 2007. The more timely Halifax and Nationwide measures suggest that house prices are moving sideways – seasonally-adjusted indices rose by 0.1% and 1.0% respectively between December and March.