Last year, the MPC warned that interest rates would have to rise if inflationary expectations became detached from the 2% target. In the June Citigroup / YouGov survey of households, the median forecast for inflation over the next 5-10 years rose to 4.1% – the highest in the survey’s five-year history.

More recently, MPC members have focused on pay trends rather than inflationary expectations as a possible trigger for policy tightening. For example, in a submission last month to the Treasury select committee David Miles said, “There is little evidence that any rise in inflation expectations has led to higher wage growth. Without a pick up in wage inflation I do not think it likely that inflation being significantly above target is sustainable.”

Private-sector regular earnings (i.e. excluding bonuses) rose by 2.6% in the year to May – the largest annual increase since January 2009. Growth averaged a slower 2.1% over the last three months but was depressed by the additional April bank holiday, which resulted in a fall in average weekly hours compared with a year ago (the earnings figures measure weekly pay). The 2.6% May increase, therefore, is probably a better guide to the trend.

The median private-sector pay settlement has fluctuated between 2.5% and 3.0% in recent months, according to Incomes Data Services. Under normal circumstances, annual growth in regular earnings is higher than a 12-month moving average of settlements, reflecting “pay drift” – the additional boost to wages from progression, interim adjustments and restructuring outside the annual review. Pay drift was running at 0.3 percentage points in early 2011 and averaged 0.6 pp over 2001-07, according to the Bank of England (May Inflation Report, p.37). Assuming no further change in settlements and a firming of pay drift in response to better second-half economic performance, private earnings growth could rise to 3.0-3.5% by early 2012.

Historically, earnings growth of 4% has been viewed as consistent with the 2% inflation target based on trend productivity (output per hour) expansion of 2% per annum. Productivity performance, however, has weakened and trend growth may now be 1.5% or less, as explained in a previous post. With the low level of sterling maintaining upward pressure on import prices, moreover, domestic unit labour costs probably need to rise by less than 2% pa for the inflation target to be met.

A rise in private-sector earnings growth to 3.0-3.5%, therefore, ought to ring inflationary alarm bells even among the MPC’s doves.

A deepening Eurozone debt crisis could disrupt the scenario but G7 real money trends continue to point to a recovery in global economic momentum during the second half.

The first chart shows six-month growth in G7 industrial output and real narrow money. The latest real money plot is an estimate for June, incorporating US and Japanese monetary data and European CPI numbers. Real money expansion picked up further last month and may have reached its fastest pace since 2009.

Real money leads output by between six months and a year. Growth bottomed in February so output momentum should revive from August at the earliest and February 2012 at the latest. An early turnaround is more likely because the slowdown in economic momentum in response to earlier monetary weakness was exaggerated by Japanese supply disruption, which is now reversing.

G7 narrow money has been growing solidly in nominal terms, with US and Japanese strength offsetting European weakness. The rise in real expansion in June, however, was driven by a slowdown in CPI inflation – second chart. Barring a renewed surge in commodity prices, this slowdown should extend, as discussed in a previous post. The inflation drag on growth, in other words, is reversing.

Emerging-world monetary trends are weaker than in the G7 but lower headline inflation will improve economic prospects by supporting real money expansion and relieving pressure for further policy tightening. E7 economies remain closely tied to the G7 cycle and are usually early to pick up shifts in global momentum. A leading indicator of E7 industrial output expansion derived from OECD data improved marginally in May – third chart.

The promising economic outlook suggested by monetary trends, of course, could be wrecked if Eurozone policy-makers fail to stem the current crisis, or if the Federal Reserve uses recent economic weakness as an excuse to launch more QE, resulting in a further surge in commodity prices.

A post in May suggested that CPI inflation would undershoot the Bank of England’s forecast over the next 12 months while remaining well above the 2% target over the medium term. The fall from 4.5% in May to 4.2% in June supports this prediction, although part of the favourable surprise reflects an earlier-than-usual start to summer sales and should be reversed next month.

The earlier post suggested that inflation would peak at 4.6% this autumn and fall below 3% in early 2012. In its May Inflation Report, by contrast, the Bank forecast a quarterly-average peak of 5.0% and a slower decline, with a two handle regained only in mid 2012.

Despite today’s better news, the inflation peak is likely to be slightly higher than indicated in the previous post because the outlook for household energy prices has deteriorated, following the announcement by market leader British Gas of gas and electricity rises of 18% and 16% respectively. The chart shows an updated profile taking into account the June figures and higher energy prices but otherwise based on the same assumptions as previously. The new suggested high is 4.8% in September / October.

Previously-targeted RPIX inflation may already have peaked at 5.5% in February, as mooted in another recent post. It fell to 5.0% in June and may rise by less than CPI inflation because of soft house prices and a slower rise in insurance premiums (which have a larger weight in the RPI than CPI).

Italian government bonds have come under pressure partly because the country’s economic recovery has ground to a halt, as reflected in very soft June purchasing managers’ survey results. (Italy’s composite PMI fell to 48.4, below the 50 break-even level and lower than Spain’s 49.2.) As usual, economic weakness was signalled six months in advance by real narrow money, which started to contract in late 2010, a development discussed in a post in December.

In general, narrow money M1 is a better leading indicator than broader measures. In the ECB’s statistics, M1 comprises currency in circulation and overnight deposits. The ECB publishes a geographical breakdown of deposits but not currency. The first chart shows six-month changes in real overnight deposits for the four large economies. Italian weakness is extreme, with a faster rate of contraction than before the 2008-09 recession.

In late 2010, in contrast to Italy and Spain, real deposits were still growing in Germany and France, implying respectable economic prospects for the first half of 2011. Now, contraction is occurring even in the core, while the pace of decline in Spain has moderated. This suggests that the recent “two-speed” Eurozone economy will give way to generalised weakness during the second half, though with Italy underperforming.

The second chart compares Italy and Spain with the other peripherals. Ireland has recently decoupled from rapid declines in Greece and Portugal, suggesting a smaller risk that renewed recession will undermine fiscal plans and trigger a second bail-out.

Among core economies, real overnight deposits are contracting at a similar pace to Greece / Portugal in Austria and Belgium – third chart. Belgian government yields have been eerily stable in recent days, despite the country’s high debt – the Italian / Belgian 10-year spread has blown out to 160 basis points (Tuesday 9.00am) from 40 bp in mid May.

There seem to be two main reasons why the MPC’s doves are trying to push the exchange rate lower by talking up the prospect of QE2.

First, the doves believe that the inflation overshoot is more than explained by a combination of the VAT hike and large increases in energy and import prices – domestically-generated inflationary pressures, in other words, are negligible. This view is reflected in a chart in the February and May Inflation Reports showing a range of estimates for the level of CPI inflation excluding the contribution of VAT and energy / import prices. This range was -0.5% to 1.3% in February and fell to -0.9% to 1.0% in the May Report.

The implication of this view is that a further surge in import prices that would follow from additional sterling weakness, far from being a development that the MPC should seek to avoid, is actually necessary to prevent inflation from falling below the target.

Secondly, the doves expect fiscal tightening and private-sector deleveraging to weigh heavily on domestic demand, implying that achievement of respectable GDP growth depends on a large improvement in net exports. To quote from Paul Fisher's interview with the Daily Mail at the start of June, which kicked off sterling's slide, “zero consumption puts a very heavy burden on the export side to deliver”. The doves have been disappointed by the lack of trade response to the 25% fall in sterling’s effective rate since mid 2007, notwithstanding better first-quarter numbers, and appear to believe that further depreciation is required to allow UK firms to gain market share.

These two arguments are, at least in the view of the author, weak. Any attempt to calculate what inflation would be “without the bad stuff” is highly speculative. The deflator for GDP at basic prices is a direct measure of domestically-generated inflation, excluding tax effects – it rose by 2.0% in the year to the first quarter, contradicting the doves’ view that the target would have been undershot but for various “shocks”. If energy and import costs had remained stable, moreover, consumers would have been able to spend more on other goods and services, pushing up their prices. Inflation would probably still be above target, driven by a stronger domestic component.

The claim that net exports must bear the burden of growth is similarly suspect. Domestic demand actually rose by a solid 4.2% in cash terms in the year to the first quarter. This, however, translated into a real increase of only 0.5% because of high inflation, for which the Bank bears partial responsibility. It is, in any case, doubtful that the tradeables sector – and particularly manufacturing – has sufficient slack to become the "engine" of growth, as the doves desire. In the April CBI industrial trends survey, the percentage of firms citing a shortage of plant capacity as a constraint on output was the highest since 1988. Under these circumstances, a further fall in sterling is likely to be reflected in higher prices rather than an increase in export or production volumes.

Banks’ reserve balances at the Bank of England have fallen by £33 billion, or 20%, since QE1 gilt purchases finished in early 2010. The MPC has not targeted the level of reserves but the Committee’s doves could use this decline to press their case for QE2.

Reserve balances reached £160 billion in early February 2010 after the end of gilt-buying in January, according to the weekly Bank return. They have since declined steadily, standing at £127 billion yesterday – see chart.

The decline in reserves has two main counterparts on the Bank’s balance sheet – a fall in longer-term repo lending to the banking system and a rise in “other liabilities”.

Longer-term repo loans have declined from £25 billion in February 2010 to £11 billion currently. Banks, in other words, have chosen to use a portion of their excess reserves to repay borrowing from the Bank.

“Other liabilities”, meanwhile, have risen from £35 billion to £49 billion since February 2010. This is puzzling but could reflect the Debt Management Office increasing the balance in its account with the Bank. If the DMO raises funds in the market and deposits them with the Bank, cash is drained from banks’ reserves accounts.

The MPC has, up to now, downplayed the role of reserves in the transmission mechanism of QE, preferring to emphasise the direct impact on yields and broad money. It would suit the doves, however, to argue that reserves must be restored to their peak level to encourage banks to lend.

The suspicion here is that the doves’ real agenda is to talk up QE2 in order to encourage further exchange rate depreciation, which they view as the sole remaining means of boosting growth. This is a dangerous strategy that threatens to push sterling into free fall, entrenching the current inflation overshoot and destabilising the gilt market.