March CPI figures confirm the prospect of another big Bank of England inflation forecasting miss in 2012. The projection here that CPI inflation will finish the year at about 2.75% may now be too low. This projection implies that December inflation will be above the 2% target for a seventh consecutive year, with a cumulative overshoot of 7.5% since the remit was switched from RPIX to CPI at the end of 2003.

The current overshoot, moreover, cannot be attributed to the various “temporary price level factors” cited by the Bank’s Governor in his unbroken sequence of nine explanatory letters since February 2010, just after a speech in which he suggested a looser interpretation of the remit – dubbed here “inflation targeting lite” and judged to represent an effective raising of the target from 2% to 3%.

March CPI inflation of 3.5% was in line with the consensus estimate but follows a significant “upside surprise” in February. The first-quarter outturn of 3.5% compares with a Bank projection of 3.35% in the February 2012 Inflation Report. A year earlier, the Bank expected inflation to be down to 2.86% by the first quarter (mean forecast based on unchanged policy).

The high reading can no longer be blamed on VAT or other indirect tax effects. The CPI excluding indirect taxes – CPIY – also rose by 3.5% in the year to March.

Part of the overshoot is explained by food and energy prices – CPI inflation excluding unprocessed food and energy was 2.9% in March. This boost, however, appears to reflect domestic pressures in these sectors rather than global commodity price developments. The S&P GSCI all-commodities spot index rose by only 1.2% in sterling terms in the year to March, down from 26.2% in the prior 12 months.

The Bank has also previously cited manufactured import price rises related to sterling weakness as a contributor to the inflation overshoot. The pound’s effective rate, however, rose by 1.5% between March 2011 and March 2012.

The February 2012 Report forecast a fall in CPI inflation to 1.87% in the fourth quarter of 2012 and 1.61% in the first quarter of 2013, based importantly on a slowdown in “core” inflation in response to assumed economic slack and better productivity performance. There is little evidence of such a decline in recent data: the CPI excluding unprocessed food and energy, incorporating adjustments for VAT changes and seasonal effects, rose at a 2.9% annualised rate between the third quarter of 2011 and the first quarter of 2012 – see chart.

The forecast here remains that CPI inflation will finish 2012 at about 2.75%, based on a small easing of core price momentum and broad stability of commodity prices and the exchange rate. Recent core resilience suggests upside risk to this projection.

The vanishing prospect of a return to target this year will be a particular disappointment to the Bank’s leading dove, Adam Posen, who, in a Guardian interview in March 2011, predicted that inflation would tumble to 1.5% by the middle of 2012 and stated that: “If I have made the wrong call, not only will I switch my vote, I would not pursue a second term.”

A leading indicator of global industrial output growth derived from the OECD’s country leading indices rose further in February, consistent with economic news remaining firm at least through May. As previously discussed, a fall in global real narrow money expansion since November 2011 suggests that output momentum will slow after May. (Real money typically leads by about six months and the indicator by about three months.)

The message that near-term news will remain satisfactory is supported by equity analysts’ earnings forecast revisions, with more estimates currently being upgraded than downgraded. The “revisions ratio” – net upgrades expressed as a proportion of the total number of estimates – correlates with forward-looking business survey activity measures, such as the PMI new orders index.

Within the global measure, a leading indicator for the “E7” large emerging economies remains stronger than its G7 equivalent, suggesting that emerging equities will sustain their year-to-date outperformance of developed markets. The E7 leading indicator also tends to correlate positively with industrial commodity prices.

The prospect of an economic slowdown later in 2012, as suggested by monetary trends, raises the issue of whether investors should position portfolios defensively. The bias here has been to delay such a defensive shift until the monetary warning signal is confirmed by a fall in the leading indicator. Such a strategy would have been “safe” in recent years; indeed, most significant equity market declines were preceded by the indicator turning negative, not just changing direction.

The liquidity backdrop for markets still seems supportive. Annual growth of global real narrow money remains above that of industrial output, a condition that has historically been associated with equities outperforming cash, as documented in previous posts. (Six-month growth rates, however, have crossed, so the annual calculation may give a “sell” signal later this year.) Aggregate bank reserves in the major economies, meanwhile, have risen to a new record, reflecting a recent injection in Japan.

A post in November argued that UK economic prospects were improving, based on an actual and prospective recovery in real broad money expansion. Recent evidence supports this forecast, suggesting that GDP growth this year will exceed the consensus estimate of 0.5%, barring renewed global turmoil.

1)    The combined output of the services and industrial sectors – 92% of the economy – rose by 0.4% in January from its fourth-quarter level. Construction could hold back first-quarter GDP but any weakness may prove temporary, judging from construction PMI results for March, showing new orders at a four-and-a-half-year high.

2)    The real broad money pick-up that formed the basis for the forecast has extended in early 2012, with six-month growth of real non-financial M4 rising to 0.6% in February – the fastest since early 2009, ahead of a spurt in economic expansion. Real narrow money M1, however, is weaker now than then, suggesting more modest GDP acceleration.

3)    The underreported first-quarter CBI financial services survey released yesterday was upbeat, with seasonally-adjusted optimism rebounding to its best level since 2009. The finance survey usually leads CBI polls of other sectors:


4)    Today’s British Chambers of Commerce survey was similarly encouraging, with seasonally-adjusted orders back firmly in expansionary territory:


5)    A more formal statistical assessment is provided by a monetary forecasting model designed to estimate the probability of a recession three quarters in advance. The model was last described in a post in October, when it suggested that the economy would skirt a recession and – on defensible assumptions – revive during 2012. The probability estimate peaked at 45% in the fourth quarter but has fallen sharply in early 2012, to below 10% (i.e. it is judged less than 10% likely that the economy will be in a recession at the end of 2012):

Signs of economic improvement should not be interpreted as validating the MPC’s decision to launch QE2 last autumn. The monetary forecasting model was suggesting a better 2012 before the additional liquidity injection – see the October post. QE2 has been stimulative but was not warranted by inflation prospects – the consensus is shifting towards the view here that the annual CPI increase will remain comfortably above 2% through 2012 and the Bank’s actions have increased the probability of the overshoot extending still further.

The G7 manufacturing PMI new orders index – a measure of global industrial momentum – slipped for a second month in March while remaining comfortably in expansion territory. The US component was again the strongest but there were upside surprises last month in Japan and the UK, while the Eurozone survey disappointed – see first and second charts.

The forecast here is that global industrial momentum will wane after May, based on a slowdown in real money supply expansion since November. This suggests that G7 PMI new orders will hold up over the spring and may reverse their February / March slippage. G7 retail sales grew solidly in the three months to February and often lead the PMI measure – third chart.

Outside the G7, the “official” Chinese new orders measure firmed last month, even after allowing for a positive seasonal effect – fourth chart. This contrasts with weakness in the alternative Markit measure but the official survey has tended to be more reliable historically.

The judgement here has been that it is too early to bet heavily on a global slowdown later in 2012 –  the monetary warning signal has yet to be confirmed by a fall in a proprietary leading indicator based on the OECD’s country leading indices, while annual real money growth is currently still above industrial output expansion, suggesting “excess” liquidity support for markets. Central banks, moreover, remain expansionary – fifth chart.

The next key data release will be a February update of the OECD leading indices on 10 April. A decline in the leading indicator, however, may occur in March (reading available in mid May) rather than February, based on an average three-month lag to real money expansion.