As foreshadowed in a post two weeks ago, December inflation numbers again surprised unfavourably, with the headline CPI rate jumping to 2.9% from 1.9% in November. This confirms the earlier forecast of a rise above 3% in early 2010, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor.

The previously-targeted inflation measure, the RPI excluding mortgage interest payments (RPIX), rose to 3.8% last month – this would already have triggered a letter under former rules, requiring explanation of a deviation of more than one percentage point from 2.5%.

The annual rate of change figures for last month are the first since November 2008 not to be distorted by the December 2008 VAT cut. They show headline CPI inflation far above the 2% target, with the bulk of the deviation due to "core" trends – the CPI excluding energy, food, alcohol and tobacco rose an annual 2.8% last month. The Bank of England's forecasts in early 2009 implied that core inflation would by now have fallen beneath 1% under the influence of the mythical "output gap". The impact of economic slack on price trends, however, has been swamped by pass-through of higher import costs due to the 27% fall in the effective exchange rate between July 2007 and March 2009 – a plunge actively promoted by Bank policy-makers.

The November Inflation Report predicted that CPI inflation would average 2.7% in the first quarter of 2010; this forecast will need to be raised significantly in the forthcoming February Report. On the conservative assumption that December's unfavourable surprise partly reflected firms adjusting prices in advance of the return of the standard VAT rate to 17.5% in January, CPI inflation may rise to 3.4% in January before falling back in February and March, averaging 3.2% for the quarter.

The pick-up in RPI inflation is proving even sharper than forecast last summer, partly because house prices have recovered more strongly than assumed. From 2.8% in December, the headline rate may reach 4-5% this spring. Historically, rising RPI inflation has had a negative impact on the poll position of the governing party – see previous post.

Governor King will be able to explain the January move in CPI inflation above 3% as the result of the VAT reversal. The persistent and significant divergence of core inflation from the 2% target, however, is more troubling and casts doubt on the sustainability of the current policy stance.

In the November Inflation Report, the two-year-ahead modal CPI inflation forecast based on an unchanged Bank rate and £200 billion of asset purchases was 2.35% – the furthest above target in the MPC's history. The Bank argued that it was justified in setting policy "too loose" for the medium term because inflation would fall significantly below 2% in the interim. Such an undershoot is now unlikely, implying that the MPC must advance its timetable for tightening if a destabilising rise in inflationary expectations is to be avoided.

A post last May suggested that house prices were bottoming, in contrast to consensus expectations at the time of a further 10-15% decline. This proved insufficiently upbeat. The Halifax index had already troughed in April and rose by 9%, or 14% annualised, over the subsequent eight months to December. The Nationwide index was also 9% above its low by December.
 
The first chart compares the quarterly evolution of real house prices since the peak in the third quarter of 2007 with their development after three prior major tops, in 1973, 1979 and 1989. (The comparison is based on the Nationwide measure, which has a longer history than the Halifax, deflated by the retail prices index.) Up to the first quarter of last year, the fall in real prices was closely tracking the major declines of 1973-77 and 1989-96. This suggested a further loss of 15-22% – roughly consistent, given inflation, with the consensus forecast for nominal prices.
 
After the first quarter, however, real prices moved sharply higher to converge with the less severe 1979-82 decline.
 
What explains the sudden shift from early 2009? The cut in Bank rate from 5.0% in September 2008 to 0.5% in March 2009 led to a steep drop in mortgage interest bills, reducing delinquencies and forced selling. Household interest payments fell from 10.5% of disposable income in the third quarter of 2008 to 6.9% a year later. This is close to the historical low (since 1987) of 6.7% in the first quarter of 2002.
 
Perhaps the decision to embark on quantitative easing in February 2009 also contributed to the shift. This may have boosted longer-term inflationary expectations, thereby increasing the attraction of housing as a store of real value relative to other assets, particularly cash savings.
 
If real house prices were to continue to follow their path after 1979, they would rise by 4% in the year to the fourth quarter of 2010 and 7% in the subsequent year. Assuming retail price inflation of 3%, the cumulative nominal gain over the two years would be 18% – sufficient for the Nationwide measure to surpass its 2007 peak by late 2011.
 
Such a scenario would imply housing remaining expensive by historical standards. As argued in the previous post, the "national rental yield" is a better measure of valuation than the house price to earnings ratio. This yield ended 2009 at about 3.4% versus a long-term average of 3.6%, implying overvaluation of about 5% – see second chart. (The yield rose slightly during 2009, despite the recovery in house prices, because of rapid growth in the national accounts rents measure.)
 
Historically-high valuations, however, may prove sustainable as long as real interest rates remain low or – in the case of cash rates – negative. The gap between the rental yield and the real yield on long-term index-linked gilts is at a record high – second chart.
 
The housing market recovery would be at risk if the MPC were to restore a positive real level of official interest rates. The consensus view, however, is that Bank rate will remain below both current inflation and the 2% target throughout 2010.

First, the annual rate of change of G7 real money supply M1 remains far above that of industrial output. As detailed in a previous post, world equities have outperformed dollar cash by 11.1% per annum on average when this condition has been met. Real money growth, however, could cross below output expansion this spring – see first chart.

Secondly, the US monetary base, having fallen in late 2009, is rebounding – second chart. A Wall Street Journal article last year by Andy Kessler argued that changes in the Fed's liquidity policy, reflected in the monetary base, were driving equities and other markets. The decline from late November was the result of a build-up of cash in the US Treasury's "general account" at the Federal Reserve, partly due to repayments of TARP funds; this reduced banks' reserves at the Fed. The Treasury, however, is now deploying this cash, reversing the impact: the general account balance rose from $13 billion on 25 November to $167 billion on 6 January but had fallen to $124 billion by 13 January.

Thirdly, US Treasury yields have fallen since the start of the year as investors have pushed back expectations for Fed tightening in the wake of last week's December employment report. The two-year yield is down by about 25 basis points.

Fourthly, US retail interest in equities remains muted but could pick up as economic news continues to improve. Equity mutual funds suffered a further outflow in December and early January, in contrast to substantial – but slowing – buying of bonds.

Some commentary has claimed that this week's Royal Institution of Chartered Surveyors (RICS) survey for December signals renewed housing market weakness. Hardly. The survey suggests a slowdown in price gains – unsurprising given a 14% annualised rise in the Halifax index over the last eight months – but a further increase in turnover.

True, the buyer enquiries index has fallen significantly from its peak in June last year. It remains, however, firmly in positive territory, consistent with further gains in mortgage approvals and transactions – see first chart. The new instructions index, meanwhile, has picked up recently but is still below buyer enquiries, suggesting that demand continues to outstrip supply.

Commentators have also interpreted the British Retail Consortium (BRC) December sales survey, showing a rise in annual sales growth from 4.1% to 6.0%, as evidence of a pick-up in consumer spending. The increase, however, may have been due to higher inflation rather than stronger volumes – the annual gain in the BRC's shop price index accelerated from 0.2% to 2.2% in December.

Manufacturing output figures for November, released today, were disappointing, showing no increase from October. Relative to its pre-recession peak, however, UK output is at a similar level to France and higher than in Germany, Japan and Italy – second chart. In other words, the smaller recent recovery in the UK partly reflects a less severe prior decline.

Markets were mildly disappointed by December US payroll numbers released on Friday, showing a monthly fall of 85,000, but the Conference Board's employment trends index (ETI) continues to signal a labour market recovery.

The ETI is designed to lead turning points in payrolls and has eight components: consumers' assessment of job availability, initial unemployment claims, small firm unfilled vacancies, temporary employment, involuntary part-time working, job openings, industrial production and business sales. It bottomed in June last year, edging higher into the autumn before rising strongly in November and December. All eight components contributed to last month's gain – more details here.

Historically, the index has led troughs in payroll employment by between one and four months – see chart. The June bottom was, therefore, consistent with a low in payrolls by October. They increased marginally in November before slipping back in December. The ETI suggests that last month's decline will be either revised away or more than offset by a rise in early 2010.

The OECD's leading indices are designed to predict industrial production and typically lead by three months or so. November figures released on Friday show further large gains across major developed and emerging economies. A combined G7 plus "E7" indicator suggests that output will continue to recover rapidly in early 2010 – see first chart.

Further evidence of resurgent industrial activity is provided by recent Asian trade data. The second chart shows combined dollar exports and imports of China, Korea and Taiwan, adjusted for seasonal variation. Both surged in December, with imports surpassing their July 2008 peak.