World industrial production – proxied by the combined output of the Group of Seven (G7) major countries and seven large emerging economies (the "E7") – resumed rapid growth in November. Based on data for six countries accounting for nearly two-thirds of the G7 plus E7 total, output rose by more than 1% after a 0.2% October decline.

G7 plus E7 production has now recovered by 9% since its February 2009 low, retracing more than half of the 16% decline from the peak in February 2008.

The rebound in G7 plus E7 output continues to mirror the recovery in G7 production following the 1974-75 recession – see first chart. (G7 output is an acceptable proxy for world production in the 1970s, when emerging economies were less significant.) This comparison suggests further solid growth in 2010 but with momentum slowing as the year progresses.

The implication of a momentum peak in the first half of 2010 is supported by monetary trends – annual growth in G7 real M1 appears to have topped in August 2009 and typically leads output expansion by about six months. E7 real M1, however, is still accelerating, suggesting that emerging economies will continue to lead the recovery – second chart.

Since its buying programme began in March, the Bank of England has swallowed up more gilts than the Debt Management Office (DMO) has issued. So which sector of the market has reduced its holdings?

The table, derived from Bank of England and DMO data, shows issuance and transactions by sector between March and October, with the prior eight months included for comparison. The Bank's buying exceeded DMO net sales by £26 billion in the latest eight months. The counterpart was a £24 billion decline in holdings of the "non-bank private sector". The combined holdings of overseas investors, banks and building societies were little changed.

The non-bank private sector comprises households, non-financial companies, insurance companies and pension funds, and other financial institutions. A monthly breakdown is not available but quarterly figures show that insurers and pension funds bought £12 billion of gilts between April and September, non-financial corporate holdings were little changed while households and other financial institutions sold £6 billion and £35 billion respectively.

The other financial category includes unit and investment trusts, other fund managers, including hedge funds, and securities dealers. Limited further information is available but the recent sales are likely to have been dominated by hedge funds and dealers.

These other financial firms have successfully traded the gilt market in recent years. They were heavy buyers before and during the financial crisis, boosting their holdings from £45 billion at the start of 2006 to £137 billion by the end of 2008. The 10-year benchmark yield averaged 4.7% over this period.

They started to unload their position in the first quarter of 2009 as the Bank began buying. Sales accelerated during the second and third quarters, when the 10-year yield averaged 3.7%. Their holdings had fallen to £96 billion by the end of September.

Gilt market optimists argue that the ending of the Bank's buying programme will be offset by stepped-up demand from insurance companies, pension funds and banks. Inflows to insurers and pension funds, however, have been weak while their liquidity ratio has fallen significantly – see chart. Banks' need to increase their holdings of liquid assets, meanwhile, has been satisfied recently by a rise in their reserve balances at the Bank of England – see memo line in table.

Yesterday's GDP figures, showing a 0.2% decline in the third quarter, disappointed economists expecting a more substantial upward revision to the previously-estimated 0.3% fall. The report's details, however, support recovery hopes and were reinforced by today's October services output number.

• A monthly GDP estimate derived from data on services and industrial output indicates that the third-quarter decline was due to a blip lower in August – see first chart. GDP is on course to post a solid gain in the fourth quarter, with the October estimate 0.3% above the third-quarter level.

• Last quarter's contraction was mainly due to lower North Sea output – GDP excluding oil and gas extraction fell by just 0.04%. This measure has declined by less than during the 1979-81 recession – 5.6% since the first quarter of 2008 versus 6.4% between the second quarter of 1979 and first quarter of 1981.

• An expenditure-based measure of GDP is more upbeat than the "official" series, which relies heavily on gloomy output data. Excluding statistical adjustments, expenditure GDP rose by 0.5% in the third quarter – second chart. This measure also suggests a later start-date to the recession, peaking in the second rather than first quarter of 2008.

• Destocking was again heavy in the third quarter, implying a substantial GDP boost as it subsides. Meanwhile, household finances have improved more rapidly than expected: the saving ratio is at an 11-year high while the debt to income ratio has fallen by 18 percentage points from its peak – third chart.

• As in the US, non-financial companies continue to run a large financial surplus (i.e. retained earnings are far ahead of capital spending) – typically a precursor of more expansionary behaviour. Excluding reinvested foreign earnings, the surplus amounted to 2.4% of GDP last quarter versus 1.3% in the US. Excess free cash flow, rather than credit supply constraints, is the main driver of the ongoing repayment of bank borrowing by companies.

In its October World Economic Outlook, the IMF forecast a rise in consumer price inflation in the advanced economies from 0.1% in 2009 to 1.1% in 2010. The increase is likely to be much larger barring renewed commodity price weakness.

The first chart shows the annual change in the consumer price index (CPI) for the Group of Seven (G7) major countries – a proxy for advanced economies – together with the 12-month movement in the IMF's world commodity export price index. The latter is projected forward assuming that commodity prices stabilise at their October level (the latest reading of the IMF index). The relationship suggests a rise in G7 annual inflation to at least 2% in early 2010 and an average for the year well above the IMF's 1.1% forecast.

Its projections for emerging and developing countries are also questionable. Spare capacity is limited in many emerging economies and consumer price indices typically assign a higher weight to commodities than in developed countries. Yet the IMF forecasts a decline in average CPI inflation for the group to 4.9% in 2010 from 5.5% in 2009.

Projected falls in Chinese and Indian inflation – to 0.6% and 7.4% respectively in 2010 – are particularly implausible. Chinese prices are likely to accelerate in the wake of 30% growth in the M2 money supply in the year to November while the Indian forecast implies a sharp reversal of the current rising trend – second chart – despite still-loose monetary policy.

The premise of this journal is that the supply of money can diverge from the demand to hold it and the difference – "excess" or "deficient" liquidity – is a key driver of markets and economies.

Implementing the approach, however, requires an estimate of the demand for money, which is unobservable. A starting-point is to assume that underlying demand depends on the level of nominal economic activity. This implies that excess or deficient liquidity expansion will be related to the gap between the growth rates of the real money supply and output.

The chart shows an index of the return on developed-market equities in US dollars relative to the return on dollar cash (three-month eurodollar deposits). The index rises from 100 at the start of 1970 to 249 at the end of November 2009. In other words, equities outperformed cash by 149% over the forty years, or 2.3% per annum.

The shaded areas in the chart define periods when annual growth in Group of Seven (G7) real money supply – on the narrow M1 measure – exceeded the rate of expansion of industrial output, suggesting excess liquidity. Equities have tended to outperform cash during such periods while underperforming when real money lagged output.

On average, equities returned 11.1% per annum more than cash when there was excess money expansion and 5.8% less when liquidity was deficient. A strategy of switching between equities and cash depending on liquidity conditions would have yielded a cumulative excess return of 873% (5.9% per annum) versus the 149% (2.3%) from a buy-and-hold policy.

Interestingly, the results are less impressive when a broad rather than narrow money measure is used to identify the liquidity environment. On average, equities outperformed cash by 6.3% per annum when G7 real broad money was rising faster than output while underperforming by 1.8% at other times.

Changes in liquidity conditions sometimes bypass developed-market equities and have their main impact on other asset classes. For example, money growth shortfalls in 1994-95 and 1997 were associated respectively with G7 bond market weakness and the Asian crisis. Conversely, excess liquidity in 2001-02 propelled property rather than equity markets higher.

Based on partial data, G7 real M1 is likely to have risen an annual 8% in November versus a 6% fall in industrial output, implying still-favourable conditions. Real money, however, has fallen short of output growth over the last six months and the annual rates of change are likely to converge by next spring as economic recovery proceeds and headline inflation rebounds.

A tide of liquidity has lifted most boats this year but is beginning to ebb. This does not preclude a further rally in equities in 2010 but the ride is likely to be bumpier than in 2009 while a sustained advance may depend on cash shifting out of other asset classes, whose prices may suffer corresponding weakness.

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.