Eurozone narrow money trends continue to weaken, signalling a sharp slowdown in economic growth in the first half of 2011.

Commentary on November monetary statistics is likely to focus on a small pick-up in broad money, M3, growth, to an annual 1.9% from 0.9% in October. Narrow money, M1, however, has been a much better economic leading indicator historically; it contracted in real terms ahead of the last recession, while M3 was still growing solidly. M1 rose by an annual 4.6% in November, down from 4.9% in October. Ominously, its inflation-adjusted level was lower than six months earlier – see first chart.

M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions. M3 also includes time and notice deposits and money market funds, making it more susceptible to changes in savings behaviour. The recent slight pick-up reflects these components and is probably related to escalating financial stress that has caused investors to hold more of their wealth in liquid form (i.e. a rise in the precautionary demand for money).

Available country M1 information suggests that the Eurozone periphery is locked into a "double dip" that will undermine fiscal consolidation plans. The ECB publishes a country breakdown of overnight deposits but not currency. The deposits analysis shows a 2.8% real contraction (not annualised) in peripheral economies – Greece, Ireland, Italy, Portugal and Spain – over the last six months. This is comparable with the decline in early 2008 just ahead of the plunge into recession – second chart. Weakness is most pronounced in Greece but real M1 deposits are falling in all five economies, with a notable acceleration in the pace of contraction in Italy recently – third chart.

Eurozone-wide real M1 trends are stronger than in early 2008, reflecting continued expansion in the core – Austria, Benelux, France and Germany. Core growth, however, has fallen sharply since the summer, suggesting a slowdown in internal economic momentum to accompany an intensifying drag from the periphery. Country figures reveal a contraction of real M1 deposits in Belgium and the smallest six-month rise in Germany since late 2008.

Revised GDP figures continue to portray a solid economic recovery, with nominal demand growing above a rate likely to be compatible with the inflation target over the medium term.

• GDP grew by 2.7% in the year to the third quarter, revised down from 2.8%. Assuming, conservatively, a quarterly gain of 0.5% in the current quarter, full-year growth will be 1.7% versus a consensus forecast of 1.3% in December 2009.

• The official GDP series relies on output data; an expenditure-based estimate rose by 2.9% in the year to the third quarter (i.e. adding back the "statistical discrepancy").

• Encouragingly, annual growth in business investment was revised up substantially, from 4.6% to 8.9%, showing that spending is responding as expected to an earlier strong improvement in corporate liquidity – see first chart. Also, the household saving ratio rebounded from 3.5% to 5.0% in the third quarter, implying that consumers have more in reserve as high inflation and tax hikes constrain real income expansion. Stockbuilding, meanwhile, was modest last quarter, at 0.1% of GDP.

• Discouragingly, the previously-reported improvement in net exports in the third quarter has been revised away, dashing the MPC's hopes that "the necessary rebalancing towards net trade might have begun" (according to the December minutes).

• The annual increase in the GDP deflator at market prices was revised down from 3.0% to 2.4%, accounting for the bulk of a reduction in nominal GDP expansion from 5.9% to 5.1%. The latter figure, however, was depressed by a large rise in the trade deficit between the third quarters of 2009 and 2010, partly reflecting surging import costs. A more appropriate focus for the MPC is nominal domestic demand, which rose by an annual 6.8% (revised from 7.1%) – the fastest since 1999.

• Relative to the pre-recession peak, GDP is slightly ahead of the level at the corresponding stage of the early 1980s recovery, which followed a recession of comparable scale (slightly deeper if measured by GDP excluding North Sea oil and gas production) – second chart.

One of the many unfair criticisms of British banks is that they have failed to "pass on" official interest rate cuts, using wider margins to boost profits. Such claims are "supported" by reference to unusually-large spreads between lending rates and Bank rate – the average interest rate on the outstanding stock of bank and building society mortgages, for example, is currently 3.0 percentage points above the 0.5% Bank rate versus an average of 0.6 points over 2005-07, before the financial crisis.

Such statistics, however, are bogus because banks are unable to obtain marginal funding at Bank rate, or even at quoted short-term interbank rates in any size. A better guide to their cost of borrowing is the average interest rate on household time deposits – currently 2.6%. The spread of the average mortgage rate of 3.5% over the time deposit rate is 0.9 percentage points, below the 1.1 point average over 2005-07 – see chart.

Net interest income, in fact, suffers rather than benefits from low official rates, partly because banks are net lenders of funds at Bank rate as a result of QE – their cash reserves at the Bank of England now stand at £140 billion, or 3.7% of their sterling assets, versus about £20 billion before the crisis. The Bank, rather than commercial banks, is enjoying a major boost to its net income, with reserve liabilities earning Bank rate used to finance a gilt portfolio with an average running yield of about 4%.

The disconnect between Bank rate and banks' funding costs undermines another common claim – that lending rates would fully reflect any rise in official rates, resulting in a squeeze on borrowers' incomes that could abort the economic recovery. With the time deposit rate so far above Bank rate, it is much more likely that this spread – rather than lending rates – would take the strain in the initial stages of any policy tightening.

An increase in Bank rate, in other words, would help to bolster the Bank's inflation-fighting credentials and cap inflationary expectations without material damage to economic prospects.

10-year Treasury yields have risen by 106 basis points (bp) from a low on 6 October and by 99 bp since a post on 5 November, drawing attention to a warning signal from the Korean bond market.

Yields could consolidate or correct lower following the recent surge; the Korean market has moved sideways since early November. Longer-term investors, however, should note that current levels continue to represent very poor value by historical standards.

The first chart shows 10-year yields, on a quarterly average basis, together with consensus 10-year consumer price inflation forecasts compiled by the Philadelphia Federal Reserve (i.e. from the Philadelphia Fed's Survey of Professional Forecasters since 1991 and from either the Livingston Survey or Blue Chip Economic Indicators for earlier years). Consensus numbers are unavailable before 1979 but can be proxied by an exponentially-weighted moving average of actual inflation.

The second chart shows an estimate of real yields calculated by subtracting the consensus 10-year inflation forecasts (or proxy numbers before 1979) from the quarterly-average nominal yields.

In the first quarter of 2009 and the third quarter of 2010 real yields stood at just 0.3% and 0.5% respectively, well below previous post-war lows of 1.2% in the late 1950s and mid 1970s and 1.1% in 2003.

At the current level of about 3.5%, nominal yields are still only 1.3 percentage points above the consensus 10-year inflation forecast of 2.2%, as reported in the fourth-quarter Survey of Professional Forecasters. To return real yields to their median level of 2.7% since the early 1950s, nominal yields would have to rise to 4.9%, assuming no change in consensus inflation views. 

CPI inflation rose to an annual 3.3% in November and remains on course to reach 4% in early 2011, reflecting the impact of soaring commodity prices, the VAT hike and a stubborn “core” trend, which continues to defy Bank of England predictions of a slowdown in response to economic slack and fading exchange rate effects.

The November rise was driven by a pick-up in goods inflation from 2.6% to 2.9% as the food, alcohol and tobacco component moved up from 5.0% to 5.8% and non-energy industrial goods inflation firmed from 1.1% to 1.4%, mainly as a result of price hikes for clothing and household goods. Food inflation remains likely to reach 7% soon, as suggested in a post in September. Energy inflation fell from 4.0% to 3.5% but is heading significantly higher as recent rises in gas and electricity tariffs take effect. A further increase in overall goods inflation is also suggested by CBI industrial price expectations – see first chart.

Services inflation moderated from 3.8% to 3.7%, mainly reflecting a slowdown in transport services, but the VAT hike is likely to push it above 4% in the new year.

“Core” CPI inflation – excluding energy, food, alcohol and tobacco – was stable at 2.7% in November.

Key influences on the headline CPI rate over the next few months will be:

• Higher VAT pass-through than a year ago – estimated upward impact of up to 0.6 percentage points (pp). The Bank’s regional agents’ survey reports that most firms plan to pass on the hike in full.

• Announced increases in home energy tariffs – about 0.4 pp by next spring.

• Higher food commodity costs – 0.2 pp assuming annual food inflation reaches 7%.

• Higher vehicle fuel costs, with unleaded likely to rise above £1.25 per litre – little impact because of a similar increase a year ago but previously-expected downward effect no longer operative.

• Secondary food price effects via the “catering services” CPI component – 0.1 pp assuming annual inflation rises to about 4% from 3.3% currently (up from 3.0% in June).

• Accelerating housing rents – 0.1 pp assuming a rise in annual inflation from 1.5% in November to about 3%. Private-sector rents are growing strongly, according to the RICS letting agents' survey – second chart.

High inflation threatens to slow the economic recovery by squeezing real incomes and money balances. By refusing to raise interest rates because of coming fiscal tightening, the Bank is encouraging high pass-through of cost-push pressures and a rise in inflationary expectations, thereby entrenching the current overshoot. Far from supporting the economy, its actions risk damaging medium-term growth prospects.

US employment figures for November were disappointing, showing a rise of only 50,000 in private-sector payrolls. Private job openings (i.e. vacancies), however, increased sharply in October, reaching a 26-month high, suggesting that employment growth will pick up in early 2011 – see first chart. (Openings are released a month later than payrolls but lead turning points in the latter by about six months.)

Job openings are rising at a similar pace to 2005, when private payrolls increased by nearly 200,000 a month. Assuming no change in government jobs, such growth would result in a steady decline in unemployment – payrolls need to rise by about 110,000 a month to keep the jobless rate stable, based on the recent rate of expansion of the working-age population and a constant labour-force participation rate.

In further evidence of improving US economic momentum, the six-month rate of change of the OECD's US leading index stabilised in October while a "leading indicator of the leading index" strengthened for the third consecutive month – second chart. This improvement is occurring on schedule following an acceleration in US real narrow money since the summer, highlighted in numerous previous posts.

The view here remains that the Federal Reserve's QE2 liquidity boost was unnecessary and is likely to prove counterproductive.