The ability of Greece and other struggling Eurozone countries to remain within EMU may depend as much on ECB support as any multilateral assistance arranged between governments.

Banks in a country perceived to be at risk of being forced out of EMU are likely to suffer an outflow of funds. The banks, in turn, will attempt to cover any funding shortfall by increasing their borrowing from the ECB.

Under current generous arrangements, banks are able to borrow from the ECB in unlimited amounts at a fixed rate against collateral rated down to BBB-. ECB President Trichet's confirmation in January of the central bank's intention to return the minimum collateral requirement to its pre-Lehman level of A- at the end of 2010 contributed to recent pressure on weaker sovereigns.

ECB support has, until now, mitigated sovereign debt problems, since banks in Greece and elsewhere have been able to purchase bonds issued by their national governments and use them as collateral to obtain cheap central bank funding. Without bank buying, yield spreads would have widened earlier and by more.

ECB lending to banks via monetary policy operations rose from €465 billion in mid 2007 to €750 billion by the end of last year. There was a simultaneous increase in banks' reserves at the ECB from €183 billion to €396 billion, partly reflecting the circulation of funds obtained by weaker banks back to stronger institutions, which redeposited them with the central bank.

Net ECB lending to banks, therefore, rose from €281 billion in mid 2007 to €354 billion by the end of 2009.

It is reasonable to suspect that this net lending has been directed disproportionately to banks in weaker Eurozone economies. The ECB does not publish a breakdown but an indication of country exposures can be obtained from balance sheet statements of national central banks.

The Bank of Finland, for example, is likely to lend only to Finnish banks. In some countries, the balance sheet statement explicitly separates transactions with domestic and other Eurozone banks.

The chart shows estimates of net lending by national central banks to local banks in the original 11 Eurozone members plus Greece (which joined in 2001) at the end of 2009, derived from these balance sheet statements. The blue bars are actual figures while the red bars are the amounts that would be implied if total ECB lending were distributed according to GDP weights.

The excess of the blue over the red bar, therefore, is a measure of the extent to which banks in a particular country are unusually reliant on ECB support.

Irish and Greek banks stand out as especially dependent on ECB funding. They account for one-third of total ECB net lending versus a combined GDP weight of 5%. Irish banks are borrowing an amount equivalent to 46% of Irish annual GDP; the corresponding figure for Greece is 17%.

The Central Bank of Ireland's net lending is inflated by transactions with international banks located in Dublin's International Financial Services Centre. Excluding institutions with predominantly foreign business, however, the total still amounts to €67 billion or 41% of GDP.

Net lending to Spanish banks is also above the implied level but amounts to a much-lower 5% of Spanish GDP. Borrowing by Portugese banks is in line with the Eurozone average while Italian banks appear to be net lenders to the ECB, i.e. their reserves exceed their borrowing.

Surprisingly, net lending to banks by the Bundesbank is greater than implied by Germany's GDP share. In this case, however, the balance sheet statement does not separate transactions with domestic and other Eurozone institutions – the total may conceal loans to banks headquartered in weaker Eurozone countries.

Greek banks may have suffered a further outflow of funds as a result of the current crisis. Reliance on ECB funding may soon approach the Irish level.

The ECB must continue to offer unlimited support if a full-scale run on banking systems in weaker Eurozone economies is to be avoided. The plan, however, to raise the minimum collateral requirement back to A- at the end of the year suggests that some within the central bank oppose a further increase in its exposure to dubious credits and could baulk at a massive Greek rescue operation.

Consumer price inflation rose to an annual 3.5% in January, in line with the consensus expectation. The figure appears to have been rounded up, since the index levels in January 2009 and January 2010 were 108.7 and 112.4 respectively, implying an increase of 3.4%. The outturn was higher than forecast in a previous post mainly because food price inflation unexpectedly accelerated – British Retail Consortium and producer output price figures had suggested a slowdown.

The rise in the headline rate from 2.9% in December is explained by the return of the standard VAT rate to 17.5%. The Office for National Statistics and the Bank of England have estimated that the cut to 15% in December 2008 reduced the CPI by about 0.7%. Assuming the same reverse effect, the headline rate may have fallen to 2.8% in the absence of the hike. (The 1.7% annual rise in the CPI at constant tax rates is misleading because it assumes that the VAT increase was passed on in full.)

CPI inflation may fall back to about 3% over coming months, partly reflecting vehicle fuel base effects and lower gas prices. The Bank's forecast, however, of a sustained decline to about 1% by early 2011 is no more credible than its projection a year ago that inflation, then 3.1%, would fall to 1.3% by the first quarter of 2010. The Bank is probably continuing to overemphasise the role of the "output gap" in the inflationary process while underestimating upward pressure on tradable goods prices from the low real exchange rate. The forecast also ignores likely further indirect tax hikes after the election while assuming a stabilisation of commodity prices and sterling.

Governor King's latest explanatory letter to the Chancellor refers to monetary policy being set "to keep inflation close to the 2% target in the medium term". The Bank's remit, however, is to achieve 2% "at all times", although allowance is made for temporary departures due to "shocks and disturbances". Governor King suggests that the VAT hike and rising energy prices represent "shocks" but the tax change was known when the Bank made its February 2009 forecast while higher commodity prices were a predictable consequence of global economic recovery.

Interpreting the remit to imply that the target applies only "in the medium term" allows the Bank maximum discretion in setting policy. When such discretion results in a persistent inflation overshoot, however, such as the 2.8% per annum rise in the CPI in the four years to January, there is a risk of expectations diverging from the target. A rise in market and / or survey-based inflation expectations could yet derail the Bank's dovish approach.

The Riksbank's latest forecasts for the Swedish economy are remarkably similar to the Bank of England's projections for the UK in the February Inflation Report. Unlike the Bank, however, the Riksbank last week signalled that it expects to begin raising interest rates in the summer or early autumn.

Sweden, like the UK, targets 2% inflation. The consumer price index at fixed mortgage rates (CPIF) rose by 2.7% in December, well above both the target and the Riksbank's previous forecast. It expects a decline to 1.2% by January 2011, however, followed by a gradual rise back to 2% by late 2012. This assumes that the repo rate is hiked from its current level of 0.25% to 2.0% by August 2011.

The Bank of England releases its forecast numbers on Wednesday but the fan charts in the Inflation Report imply CPI inflation of more than 3% in the current quarter followed by a decline to about 1% in early 2011 and a rise back to 2% in late 2012 (mean projection). This is based on market expectations of an increase in Bank rate to 2.1% by the third quarter of 2011.

The similarity of the two forecasts is illustrated by the charts, taken from the Inflation Report and Riksbank Monetary Policy Report respectively.

Spare capacity is probably similar in the two economies. From a peak in the first quarter of 2008, GDP had fallen by 5.9% in Sweden and 6.0% in the UK (5.6% excluding oil and gas extraction) by the third quarter of last year. As in the UK, Swedish unemployment has risen by less than most forecasters, including the Riksbank, expected.

Both central banks project a solid economic recovery. The Riksbank forecasts GDP growth of 2.3% in 2010, 3.4% in 2011 and 3.5% in 2012. The Financial Times estimates that the Bank's mean projection is for increases of 1.3%, 3.0% and 2.9% respectively. While the UK numbers are lower, the OECD thinks that potential growth was 0.4-0.5% per annum slower in the UK than Sweden over the last five years.

The Bank's inflation forecast is probably optimistic relative to the Riksbank's, for three reasons: inflation is starting from a higher level, which is likely to influence expectations; sterling has been much weaker than the Swedish krona, suggesting continuing upward pressure on tradable goods prices; and the UK's much-worse public finances guarantee further large rises in indirect taxes.

According to the Riksbank:

The information received since December indicates a continued normalisation of the financial markets and a somewhat stronger development of the economy. All in all, this means that the risk of a major setback in the recovery of the economy has declined and that the upturn therefore rests on more solid ground. There may thus be a need to adjust monetary policy to more normal conditions somewhat sooner than was assumed in December. The current assessment of the Executive Board of the Riksbank is that the repo rate will be increased in the summer or early autumn.

Compare and contrast with the closing sentences of Bank of England Governor King's statement at last week's Inflation Report press conference:

Output has stabilised and confidence has recovered. The additional money created by the asset programme will continue to boost the economy for some time to come. But the nature of the headwinds means that the recovery is likely to be slow. And there is much uncertainty – about both the outlook for the world economy and the strength of domestic spending. Although the MPC last week announced a pause in its programme of asset purchases, it is far too soon to conclude that no more purchases will be needed. So the Committee will keep its options open, and further purchases will be made if they prove necessary to keep inflation on track to meet the target in the medium term.

The Bank of England's optimistic inflation forecast and its unwillingness to signal the possibility of future tightening may be further evidence of a shift to "inflation targeting lite", in which the formal requirement to hit the 2% target "at all times" is downplayed in favour of supporting growth and encouraging politicians to believe that necessary fiscal restriction will be rewarded by maintenance of super-low interest rates.

The US monetary base rose again in the week to Wednesday, consistent with the forecast in Tuesday's post – see first chart. As previously discussed, markets have recently been sensitive to fluctuations in the base so this pick-up may support a near-term rally in equities, possibly accompanied by a weaker or stable dollar.

The reversal of the year-end contraction in the US monetary base may also have contributed to a recent resumption of capital inflows to Hong Kong. Under the currency board arrangement such inflows automatically expand the territory's own monetary base – first chart.

A post in October suggested that the Dow industrial index might follow a path similar to the recoveries after the 1906-07, 1919-21 and 1973-74 bear markets. The second chart provides an update: the Dow recently moved below the range spanned by the three rebounds, hinting at a buying opportunity.

One caveat to a positive view is that annual growth in G7 real money supply M1 is likely to cross below that of industrial output expansion this spring – historically, equities have underperformed cash on average under such circumstances. This analysis, however, allows for near-term market gains before the macro liquidity backdrop turns less favourable.

Markets are also concerned that China's policy tightening – banks' reserve requirement ratios were raised by a further 50 basis points today – will lead to a hard landing for its economy. This hinges on whether a large positive "output gap" has already developed – if so, much higher inflation is inevitable and the authorities will be forced to slam rather than tap on the brakes.

Output gap estimates are even flakier for China than elsewhere but two pieces of evidence suggest that the economy is not yet "overheating": industrial output is slightly below its trend over the last 10 years – third chart – while companies were not reporting skilled labour shortages late last year – fourth chart. A managed slowdown may still be possible.

The February Inflation Report is more dovish than expected but the Bank of England has failed to provide an explanation of the significant inflation overshoot relative to its forecasts, casting doubt on the credibility of its current projections. The suggestion is that the forecast is being adjusted to fit the policy rather than vice versa.

Key points:

• While forced to raise its near-term inflation profile, the Bank has revised down its medium-term forecasts: the two-year-ahead modal projection based on unchanged policies is now below 2% versus 2.35% in the November Report. It is difficult to believe that this change was warranted by the modest downward revision to its growth forecast, which continues to envisage a solid recovery.

• Governor King's claim that the current overshoot relative to the Bank's forecasts can be explained by higher energy prices is unconvincing. The February 2009 Report projected inflation of 1.3% in the first quarter of 2010 based on unchanged policies. If the Bank had used its current energy price assumptions, the forecast would have been about one percentage point higher, i.e. 2.3%. Inflation is now expected to be about 3.3% this quarter, despite a much larger GDP fall than the Bank predicted last February. In other words, there is an unexplained forecast error of at least a percentage point.

• The most likely explanation for this error is that the Bank overestimated the disinflationary impact of economic slack while underestimating upward pressure on traded goods prices from exchange rate depreciation. The cut in the medium-term inflation forecast, however, suggests that the emphasis on the "output gap" has, if anything, increased. The Bank, meanwhile, continues to assume that the impact of sterling weakness will be temporary; the alternative view is that the low real exchange rate will exert further upward pressure on UK goods prices relative to the global trend over the medium term.

• A likely significant rise in indirect taxes after the election will boost inflation relative to the Bank's forecasts. In a recent speech, Governor King suggested that the MPC would ignore "temporary price level factors" – defined to include commodity price rises, sterling depreciation and tax increases – when setting policy. It is debatable whether such an approach is compatible with the MPC's remit, which is to achieve the 2% target, defined by the consumer price index without any exclusions, "at all times".

A previous post argued that how the MPC interprets its remit would be as important for the interest rate outlook this year as the evolution of inflation and output. Today's Report reinforces suspicion of a shift to "inflation targeting lite", involving downplaying "exogenous" upward influences on inflation and placing more weight on forecasts and discretion. Accordingly, any policy tightening is now unlikely before May at the earliest.

The recent set-back in markets may partly reflect worries about a withdrawal of liquidity support by the Federal Reserve and other central banks. Such concerns are premature: the US monetary base is likely to reach a new high this spring.

The Fed plans to complete its purchases of about $1.425 trillion of agency debt and mortgage-backed securities by the end of March. As of last week, its balance sheet contained $1.135 trillion of such securities, implying $290 billion yet to be added.

Payment for this $290 billion will be made by crediting banks' reserve accounts at the Fed, which – together with currency – constitute the monetary base. Other things being equal, therefore, the base will rise from its current level of $2.037 trillion to $2.327 – a 14% increase.

The Fed, however, is simultaneously closing several liquidity support operations, including the term auction facility, the commercial paper funding facility and swap arrangements with other central banks. Lending under these facilities totalled $47 billion last week. In addition, banks may choose to repay the $16 billion of discount window loans still outstanding.

The $290 billion addition to the monetary base from securities purchases, therefore, will be offset by a repayment of up to $63 billion of emergency support, suggesting a net increase of $227 billion or 11% – see table.

The Fed, in theory, could sterilise this injection, by selling Treasury securities or running down "other" assets, asking the Treasury to hold more cash in its account, or conducting reverse repurchase agreements (included in "other" liabilities). Officials, however, are likely to view a further expansion of the monetary base as desirable given ongoing worries about the sustainability of the revival in the economy and markets.