News that three MPC members voted to expand QE at the February meeting surprised markets, leading some commentators to claim that the Committee’s “reaction function” has changed to allow higher inflation. While this is possible, the vote was consistent with the prediction of the “MPC-ometer” model followed here – it was, in other words, explicable by recent data.

The MPC-ometer predicts the outcome of each month’s meeting based on the latest values of 12 economic and financial inputs, including business survey activity measures, the quarterly GDP change, manufacturers’ price-raising plans, consumer inflation expectations, credit spreads and equity prices. The forecast is in the form of the “average interest rate vote” of the Committee’s members; for example, if four vote to cut Bank rate by 25 basis points (bp) while five prefer no change, the average vote is -11 bp (i.e. four-ninths of -25 bp). The February prediction was -9 bp, consistent with three members voting for a 25 bp rate cut. The same number, instead, sought to expand the QE programme by £25 billion.

The February forecast was influenced by the weak fourth-quarter GDP estimate and also took into account the tendency for policy changes to occur in Inflation Report months. The dovish impact on the model of the GDP number will drop out next month, although the bias revealed by the three February dissents works in the opposite direction. With seven inputs available, the current prediction for March is -4bp, suggesting that a majority will again vote for no change. The final reading will depend importantly on any fourth-quarter GDP revision and February consumer and purchasing managers' surveys. (The chart incorporates the current March estimate.)

The Bank of England’s efforts to revive borrowing have dealt a further heavy blow to bank and building society savers in recent months. A faster erosion of the real value of such savings may trigger an upward shift in the velocity of circulation of money, with longer-term inflationary consequences.

According to Bank data, the average gross interest rate on new two-year fixed-rate bonds fell from 3.24% in June 2012, just before the introduction of the Funding for Lending Scheme (FLS), to 2.23% in January. The rate on instant-access deposits, including bonuses, declined from 1.55% to just 1.04% over the same period.

The prospective real return on such investments has suffered an even greater drop because the Monetary Policy Committee (MPC) has sanctioned a higher inflation rate. In the May 2012 Inflation Report, the consumer prices index was forecast* to rise by 2.1% per annum over the subsequent two years. In the February 2013 Report, this two-year projection was raised to an estimated 2.6%. The prospective real interest rate on two-year fixed-rate bonds, therefore, has fallen from 1.1% in May-June last year to -0.4% currently. The position, of course, is much worse for tax-payers and / or those unable to tie up their cash for two years.

A cut in savings rates was an inevitable consequence of supplying banks with cheap funds via the FLS, thereby reducing their need to bid for retail deposits. The scale of the declines, however, may have surprised the MPC, while the pass-through to borrowing rates has been disappointing. The average interest rate on new two-year fixed-rate 90% loan-to-value (LTV) mortgages fell by 97 basis points (bp) between June and January but the reduction was 64 bp for 75% LTV deals – below the 101 bp cut in the equivalent-term savings rate. The impact on floating rates has been even less: new two-year 75% LTV loans cheapened by only 16 bp between June and January, while average standard variable rates and overdraft rates have risen.

Banks are required to maintain or grow their loan books to qualify for the cheapest FLS terms. The above evidence suggests that they have reduced borrowing rates by the minimum necessary to achieve this goal, allowing the remainder of the cut in funding costs to boost spreads. A rise in banks' margins is desirable to allow them to build capital in order to support future lending but the current increase appears excessive. Savers, in other words, are paying too high a price to achieve the reduction in borrowing rates craved by the MPC.

Aside from distributional arguments, increasing the effective penalty for holding bank and building society deposits risks triggering a sharp reduction in the demand to hold such money, with inflationary consequences. An individual can cut his or her money holdings by investing in other assets or buying goods / services but this is not possible for the economy as a whole – “excess” money passes like a hot potato to other individuals, who undertake their own corrective transactions. Reduced money demand, in other words, results in a rise in the velocity of circulation, with an identical impact to additional monetary expansion.

The Bank’s M4ex broad money aggregate grew by an annual 5.2% in December while the velocity of this measure has risen by an average of 1% per annum since the recession trough in the second quarter of 2009. The latter trend could plausibly increase to 2-3% as money-holders anticipate faster erosion of their purchasing power – velocity rose by 5-6% a year during the late 1970s when real interest rates were last heavily negative. Unless monetary trends weaken significantly as a result of the suspension of QE, therefore, the sum of money growth and the trend velocity rise is likely to exceed the 4-5% per annum compatible with an optimistic assessment of potential economic expansion and achievement of the 2% inflation target.

*Mean forecast based on unchanged policy.

Based on data covering 60% of the aggregate, G7 plus emerging E7 six-month real narrow money expansion slowed slightly further in January, having peaked in October 2012. Growth, however, is still respectable by historical standards, at an estimated 3.4% or 6.9% annualised – see first chart. Allowing for the typical half-year lead, this suggests that global economic momentum will peak in spring 2013 but remain solid into the summer.

Global activity is picking up on schedule in response to the revival in real money expansion between April and October last year. G7 plus E7 six-month industrial output growth rose to an estimated 1.2% (2.4% annualised) in December – the fastest since May. With real money now slowing, the gap between its rate of change and that of output is narrowing, indicating that “excess” liquidity available to flow into markets and lift asset prices is diminishing. According to research presented in a previous post, however, equity bear markets normally begin only after real money expansion crosses beneath industrial output growth.

The second chart shows six-month real money growth for countries that have released January monetary data. US real money expansion has slowed but remains relatively strong, consistent with the recent outperformance of US equities. Japanese growth is solid but the Bank of Japan’s stepped-up easing efforts have yet to give a further boost. A pick-up in Chinese real money expansion supported the global measure in January but may reflect a New Year timing effect, implying an unwind in February – see previous post. The final global reading for January will depend importantly on Eurozone monetary data to be reported on 27 February.

The shorter-term leading indicator followed here suggests that global growth will strengthen into the spring – see Monday’s post. The following charts provide some country detail.

The first chart shows indicators for the G3 plus the UK. The latest readings are all positive; between February 2010 and September 2012, at least one was negative in every month bar one (February 2012). The current pick-up, therefore, has breadth. Another standout is the speed of recent improvement in Japan.

The second chart separates out the big four Eurozone economies. This is less encouraging, with German buoyancy and Italian improvement contrasting with weakness in France and, especially, Spain. This divergence is also evident in real narrow money trends – see previous post. Without a balanced recovery, doubts about the sustainability of the Eurozone in its current form are likely to persist.

The final chart shows the six-month rate of change of the Journal of Commerce index* of industrial commodity prices together with a leading indicator for the emerging E7** countries, which drive incremental demand for raw materials. The continued rise in the indicator suggests that the recent rally in commodity prices will extend, in turn putting upward pressure on inflation rates globally later in 2013.

*Covering 18 materials used in manufacturing production including crude oil and natural gas.
**Defined here as BRIC plus Korea, Mexico and Taiwan.

A key summary measure of each Inflation Report is the Bank of England’s “mean” forecast for inflation in two years’ time based on unchanged policy. (The mean forecast incorporates upside and downside risks as well as the central projection.) Historically, a forecast above the inflation target has signalled a tightening bias to policy, and vice versa.

In today’s February Report, the two-year-ahead mean inflation forecast appears to be 2.3-2.4%* versus 1.80% in November. This is the highest since early 2011: the forecasts in February and May 2011 were 2.48% and 2.54% respectively – see chart. The MPC came close to tightening policy in early 2011; three members voted to hike rates between February and May.

The current MPC, of course, has no such bias. Indeed, the Report states that the Committee stands ready to provide additional stimulus without mentioning a possible need to tighten policy should the inflation outlook continue to deteriorate. This is likely to sustain the recent upward drift in longer-term inflation expectations, which are already barely consistent with the target. The MPC's nonchalance, in other words, risks undermining the (questionable) inflation / growth trade-off it seeks to exploit.

*Estimated from the fan chart; the precise number will be available next week.

UK consumer price inflation was stable at 2.7% in January but the forecast here remains for it to rise to more than 3.5% by mid-year and hold above 3% into 2014.

Sustained above-target inflation in recent years reflects a combination of a stubborn core trend and upward pressure on energy and food prices due mainly to rising emerging-world demand. Both should persist.

Core inflation can be measured by the annual change in the CPI excluding energy and unprocessed food adjusted for VAT changes and last year’s hike in undergraduate tuition fees. This was an estimated 2.3% in January and has been above 2% in 54 of the last 57 months – see first chart. Core inflation is expected to firm later in 2013 and in 2014 in lagged response to stronger money supply growth, based on the Friedmanite forecasting rule discussed in previous posts.

The near-term rise in inflation, however, will be driven by energy / food. Assuming no change to the current wholesale price, unleaded petrol should climb from 132 pence per litre in January to about 138 pence – second chart. Household energy bill inflation will increase further as tariff cuts in early 2012 drop from the annual comparison. Food price inflation may rise from 4.5% in January to 6-7% as higher input costs are passed on – third chart.

Energy and food are included in the CPI goods index, which should also capture most of the impact of recent exchange rate weakness. CPI goods inflation is forecast to rise from 1.9% in January to about 3.5% by mid-year, a scenario supported by CBI industrial firms’ price expectations – fourth chart. With goods accounting for 53% of the basket, this would be sufficient to lift the headline CPI rate to 3.5%, assuming stable services inflation.