A strong acceleration in global real money supply growth in late 2008 suggested that economic activity would bottom in spring 2009 and recover during the second half – see here and here. Recent news remains consistent with this scenario.

Industrial output in the Group of Seven (G7) major economies fell by 19% between February 2008 and March 2009 but has recovered by 1% by May. This reflects a rebound in Japan, Germany and France, which had suffered more severe declines, offset by a continuing slide in the US, partly reflecting auto sector woes.

Purchasing managers' surveys show that new orders are stabilising while companies are still cutting stocks. As destocking slows, firms will need to place additional orders with suppliers, who in turn will be forced to raise production. The second-quarter Conference Board Chief Executive Officer survey released earlier this week signals an imminent recovery in US industrial output – see first chart.

The big story of the first half, however, has been the rebound in emerging economies – second chart. Industrial output in seven large emerging economies – the BRICs plus Korea, Taiwan and Mexico – rose by 3% in the six months to May versus a 10% contraction in the G7. Surveys indicate further acceleration.

This "E7" pick-up is not just about China – third chart. Output is on a rising trend in five of the seven economies, the exceptions being Mexico – which will benefit from a US recovery – and Russia. This reflects a rebound in world trade and effective monetary stimulus in economies where banking systems are still functioning normally.

Emerging world strength coupled with improving G7 prospects suggest that a solid "Zarnowitz" recovery in global activity remains possible – see here and here for a discussion. Credit supply constraints in developed economies are not an immediate obstacle to this scenario since credit demand is usually weak in the first year of economic upswings.

There are two key risks. First, labour market deterioration could lead to a further lurch down in consumer spending, aborting the stocks-led industrial recovery. The US June employment report was disappointing but leading indicators give a more hopeful message – for example, the number of job cuts announced last month was the lowest since March 2008, according to outsourcing firm Challenger, Gray and Christmas.

Secondly, real money growth could slow as weak credit trends offset QE and higher commodity prices lift inflation. This is less of a concern in the US and UK – the Fed and MPC are likely to calibrate asset purchases to ensure stability – than the Eurozone, where M3 is stagnant and the effectiveness of the ECB's QE alternative is in doubt.

There are three possible reasons for the MPC's decision today to maintain the asset purchase programme at £125 billion, against expectations of an increase.

First, the Committee may judge that the scheme is working as planned and there is no need for a further expansion. Arguments in favour of this view include recent stronger broad money growth and improvements in loan availability reported in last week's Credit Conditions Survey.

Secondly, and more likely, the MPC is inclined towards an extension but wishes to slow the pace of buying and avoid the impression of an open-ended commitment. The August Inflation Report forecasting round provides a convenient excuse for deferring an announcement, while maintaining the £125 billion cap will automatically cut gilt-buying from £6.5 billion to £4 billion per week.

Thirdly, and least likely, the MPC judges that any positive effects are small relative to possible damage to its inflation-fighting credibility from continuing with the policy.

The absence of any guidance about these alternatives in the MPC's news release is surprising and may indicate disagreement within the Committee.

A reasonable strategy would be for the MPC to utilise the £25 billion still available under the existing authority in August while spreading purchases over two months, implying a further slowdown to £3 billion per week. Assuming more evidence of positive effects and wider economic improvement, the programme could be suspended at the October meeting.

A previous post used Bank of England effective interest rate data to show that – contrary to the consensus perception – UK banks' aggregate net interest margin on sterling business remained stuck close to a record low. The margin, however, was expected to improve gradually as high-cost term funding was refinanced at lower rates and banks began to benefit from wider spreads on new lending.

May effective rate statistics released last week are consistent with this story. The average interest rate charged on M4 lending was unchanged on the month, while the average rate paid on M4 deposits declined, mainly reflecting falls on time deposits and notice accounts – see chart. The spread, or net interest margin, therefore rose to its highest level since January.

This may, in fact, understate the improvement in net interest income since banks have also benefited from a falling cost of wholesale funding needed to plug the £490 billion gap between M4 lending and deposits. The spread between three-month unsecured and secured interbank borrowing rates has fallen from 120 to 50 basis points since the start of 2009.

Higher net interest income is needed to provide resources to cover write-offs and support future lending. The current M4 lending / deposit rate spread of 2.1 percentage points compares with an average of 2.8 over 1999-2008. A return to this average would boost UK bank's pre-tax profits by £14 - 17 billion per annum.

The Office for National Statistics this week revised the fall in UK GDP in the first quarter from 1.9% to 2.4% but monthly figures on output in the services and production sectors – which account for 93% of GDP – indicate that the pace of contraction slowed during the quarter and the economy may have stabilised in April.

The chart shows official quarterly GDP, rebased to the peak level in the first quarter of 2008, together with a monthly proxy based on the services and industrial output data. The proxy was unchanged in April – the first month not to register a decline since September. The monthly numbers are subject to revision but the April reading is consistent with better purchasing managers' survey results, which improved further in May and June.

The monthly proxy was 0.3% below its first-quarter average in April so the preliminary second-quarter GDP estimate released on 24 July is likely to show a further fall. This should, however, be the smallest since a 0.1% drop in the second quarter of 2008.

Today's Financial Times contains another downbeat article about the UK's QE. One fund manager quoted is disappointed that no effect on RPI trends is yet apparent. Since the latest RPI number refers to a period only two months after QE started, while monetary changes typically take two years to have their full impact on prices, this might be considered unsurprising.

Another interviewee correctly links an assessment of the success of QE with money supply figures. Unfortunately, he proceeds to ignore the recent broad money pick-up, referring instead to weakness in bank lending to non-financial corporations. Money and credit are routinely confused in discussions of QE, with few commentators aware that money leads the economy while credit lags.

Contributors to the FT article may not have read the Bank of England's excellent explanation of the aims and mechanics of QE, available on its website. As well as expanding QE to £150 billion at next week's meeting, the MPC might consider stepping up its education programme.

Further evidence that QE is beginning to work is provided by the Bank's second-quarter Credit Conditions Survey released today, showing that a majority of banks made more credit available to mortgage borrowers and companies over the last three months, with a further improvement expected this quarter.

The results of similar surveys in other major economies are usually expressed in terms of the net percentage of banks tightening rather than loosening credit. When the Bank's survey is converted to the same format, the UK results compare favourably – see chart for corporate lending responses. This reflects the combined impact of QE and lending commitments made by the Lloyds Banking Group and the Royal Bank of Scotland as a condition of their participation in the Asset Protection Scheme. (The UK is the first country to publish a second-quarter survey.)

This note examines the outlook for consumer and retail price inflation in 2010-11 from a "monetarist" perspective. The approach is to build up a forecast by considering in turn "core" inflation, VAT effects, food and energy prices and owner-occupied housing costs (relevant for the RPI).

The conventional "Keynesian" approach is to model core inflation as a function of the "output gap" with some allowance for the effect of exchange rate movements on import prices. The trouble with this is that the output gap is difficult to measure, particularly in real time, while currency movements are largely unpredictable. The consensus view, embodied in the MPC's Inflation Report forecast, is that a large negative gap has opened up and will persist in 2010-11, exerting sustained downward pressure on core inflation. Yet the financial crisis may have damaged supply capacity by more than the consensus assumes, by raising the cost of capital, disrupting its efficient allocation and reducing the sustainable size of the financial sector – the Treasury has cited estimates of a negative effect on potential GDP of up to 6%. History suggests that caution is warranted: an overestimate by policy-makers of the degree of economic slack contributed to the inflationary upsurge in the 1970s.

An alternative approach is to base a forecast for core inflation on the simplistic monetarist rule-of-thumb that the money supply leads prices with a variable lag averaging about two years. The monetarist rule has arguably performed much better than output gapology in recent years: a large fall in core inflation in the late 1990s was preceded by a major monetary slowdown, while faster money growth forewarned of the inflationary overshoot of 2007-08. The late 1990s disinflationary episode can be used to calibrate the possible impact of recent monetary weakness on core inflation. Annual growth in broad money M4 fell from 11.9% to 2.8% between Q4 1997 and Q3 1999 – a 9.1 percentage point drop. Annual core inflation – as measured by the CPI excluding unprocessed food and energy – subsequently declined by 1.9 percentage points to a low of just 0.1% in July 2000. So the "elasticity" of inflation to monetary growth was 0.21 (i.e. 1.9 divided by 9.1). Recent monetary trends are best measured by the Bank of England's adjusted M4 measure, excluding money holdings of financial intermediaries. Its annual growth rate fell from 11.6% in Q3 2006 to 3.6% in Q4 2008, rebounding to 4.2% in Q1 2009. Assuming that Q4 2008 was the low – reasonable given the positive impact of Bank of England gilt purchases in Q2 and Q3 2009 – the monetary slowdown suggests an eventual fall in annual core inflation of 1.7 percentage points (i.e. multiplying the money growth decline of 8.0 percentage points by the inflation elasticity of 0.21).

A major difference, however, between the late 1990s and now is a higher starting level of core inflation. The CPI excluding unprocessed food and energy rose by an annual 2.1% in May compared with 2.0% in February 1998, when the prior big slowdown began. However, recent numbers have been flattered by the temporary cut in the main rate of VAT from 17.5% to 15% last December. Assuming average pass-through of 60%, the core CPI measure would have risen by an annual 2.9% in May in the absence of the VAT change, down from a peak of 3.0% in February. (The 60% assumption may be conservative – the Office for National Statistics has estimated that 70% of prices collected from shops had been reduced to reflect the lower VAT rate in January.) Applying the predicted 1.7 percentage point fall in annual core inflation to the 3.0% February peak, the monetarist approach suggests an eventual trough of 1.3% – well above the 0.1% low reached in 2000. Assuming a two-year lead of money on prices, this trough could be reached around the end of 2010, with the recent recovery in monetary growth reflected in higher core inflation in 2011.

The outlook for headline CPI and RPI inflation will also depend on future VAT effects, food and energy prices and housing costs. The forecasts below assume that the planned return in the main VAT rate to 17.5% from January 2010 goes ahead, again with average pass-through of 60%. A further 1 percentage point increase is pencilled in for January 2011, on the basis that higher VAT will bear some of the burden of future fiscal consolidation. Unprocessed food inflation – still running at an annual 9.3% in May – is assumed to fall significantly by the end of 2009 but to remain positive, reflecting a judgement that the large increase in prices over 2007-09 reflected a "structural" shift. Following a modest further cut in retail tariffs later this year, energy prices are similarly projected to trend gradually higher. For the RPI forecast, the components linked to house prices are assumed to stabilise from late 2009 after a 20% drop from the peak. Finally, the average mortgage interest rate – currently 3.6% – is projected to fall slightly further over the remainder of 2009 before recovering by about 1 percentage point during 2010, reflecting an assumed rise in Bank rate from 0.5% to 2.5% next year.

The results of this exercise are shown in the chart. Annual CPI inflation falls from its current 2.2% towards 1% by autumn 2009, reflecting favourable food and energy price effects, but rebounds to about 3% in early 2010 as VAT is hiked. Slower core trends gradually reverse this increase and inflation moves temporarily below 2% again in early 2011 as a result of VAT effects (i.e. a smaller rise in 2011 than 2010), before drifting higher later in the year in lagged response to the current pick-up in monetary growth. Mirroring the CPI profile, the annual RPI change moves deeper into negative territory into the autumn but increases much more sharply in 2010, with the VAT increase compounded by a big turnaround in the housing costs component, reflecting both unfavourable base effects and higher mortgage rates. Annual RPI inflation peaks at about 3.5% in late 2010, slowing temporarily during the first half of 2011 as housing effects wane.

Two features of this forecast are worth emphasising. First, the CPI profile is significantly higher than the central projection in the May Inflation Report, which shows average inflation of 1.5% this year, 0.9% in 2010 and 1.3% in 2011. The difference mainly reflects the sustained disinflationary influence of a negative output gap in the Bank of England's forecasting model, although assumptions about VAT and commodity prices may also contribute. The MPC's recent forecasting record warrants some scepticism about its current prognosis: the central projection for annual CPI inflation one year ahead has been too low in 15 out of 17 Inflation Reports between February 2004 (after the inflation target was switched to the CPI from RPIX) and February 2008, with a mean forecast error of 0.7 percentage points.

Secondly, the swing in RPI inflation between 2009 and 2010 is unusually large and may have negative economic implications. Wage growth has slowed sharply since the onset of the recession in spring 2008 but it is unclear whether this reflects labour market flexibility or is simply a response to annual RPI falls. A pick-up in wage settlements as RPI inflation rebounds in 2010 would cast doubt on the MPC's view that economic slack will drive core price trends significantly lower. On the other hand, continued weak wage growth would imply a squeeze on real disposable incomes, potentially undermining prospects for consumer spending and an economic recovery.