The story so far:

US and global equities have been following fluctuations in the US monetary base (i.e. currency plus bank reserves) over the last 18 months – see first chart. The most recent low in the base occurred in early May; the Dow Industrials index troughed five weeks later. The subsequent recovery in the base, however, stalled a month ago, suggesting that the rally in equities may be in the process of rolling over.

More positively, the Eurozone monetary base on an expanded definition including one-week term deposits – likely to be regarded by banks as a close substitute for reserves – has continued to rise strongly in recent weeks. The environment is reminiscent of June / July last year: the US monetary base moved sideways but the Dow rallied following a surge in the Eurozone base.

In contrast to then, however, the macroliquidity fundamentals are less favourable, with G7 real M1 growing more slowly than industrial output – see prior post. The stalling of the US monetary base in summer 2009, moreover, was clearly temporary given the Federal Reserve’s quantitative easing plans.

These various cross-currents may mean that equities continue to fluctuate in a trading range that frustrates both bulls and bears, an outcome also suggested by the “six-bear comparison” discussed in previous posts – second chart.

A more positive outlook would be signalled by Fed action to boost US monetary base. The most likely form would be a suspension of the “supplementary financing program” under which the Fed has borrowed $200 billion from the Treasury – repayment of this sum would inject an equivalent amount into bank reserves.

The Chancellor delivered a decisive Budget that should greatly reduce worries about fiscal sustainability. The composition of the measures announced was also welcome, with an emphasis on current spending reductions and indirect tax rises that should be less damaging to economic performance.

However, the new fiscal mandate – to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period – is unconvincing. Estimates of the cyclically-adjusted balance are highly uncertain and it is doubtful that the rule, even if monitored by the new Office for Budget Responsibility (OBR), would have constrained the fiscal policy of the last Government.

Other points:

• The additional £40 billion of savings by 2014-15 announced today builds on £73 billion implied by the previous Government's plans, bringing the total to £113 billion – equivalent to 6.3% of projected GDP in that year. Spending cuts account for £83 billion, or 74%, of the overall adjustment.

• While the Chancellor focused his axe on current spending, capital investment continues to bear an excessive burden of the overall adjustment, mainly reflecting the previous Government's plans. Investment is projected to fall by 42% in real terms between 2009-10 and 2014-15, accounting for two-thirds of a 7% fall in total managed expenditure excluding interest payments.

• The cyclically-adjusted current balance is forecast to be in surplus by 0.8% of GDP at the end of the five-year forecast period in 2015-16, implying that the Chancellor has built in about £15 billion of leeway that he will be able to "give away" before the next election. Put differently, he could have avoided raising the standard VAT rate to 20%, raising £13 billion by 2014-15, and still achieved the fiscal mandate.

• The OBR's assumptions about the longer-term impact of fiscal tightening on growth assist the Chancellor but will displease Keynesian economists. The OBR forecasts that real GDP will be 0.3% lower in 2014-15 than in its pre-Budget forecast despite a 2.0% of GDP reduction in cyclically-adjusted borrowing, suggesting a fiscal multiplier of only 0.15. (The OBR warns that its earlier forecast may have been biased up, in which case the true multiplier would be even lower.)

• The OBR's forecast of public sector net borrowing of £149 billion in 2010-11 looks overly cautious in light of recent encouraging monthly numbers, suggesting an outturn of below £130 billion – further grounds for questioning whether a VAT rise was necessary at this stage.

The transfer of responsibilities to the Office for Budget Responsibility (OBR) is unlikely to result in an improvement in fiscal forecasting, which is notoriously difficult.

The OBR this week projected a fall in public sector net borrowing excluding the temporary effects of financial interventions (PSNB ex) from £156.1 billion in 2009-10 to £155 billion in 2010-11. Recent trends suggest a significantly smaller deficit. May public finances numbers released today revised down the 2009-10 outturn to £154.7 billion. More importantly, monthly borrowing including intervention effects, after attempting to adjust for seasonal factors, has been running at about £10 billion recently, or £120 billion annualised – see chart. Assuming no further change, this is consistent with the PSNB ex measure falling to £126 billion in 2010-11, based on the Treasury's March forecast that intervention effects would reduce headline borrowing by £6 billion this year. (PSNB ex figures are currently available only quarterly but will be published on a monthly basis from July.)

The OBR's caution in extrapolating recent better trends is helpful for the Chancellor as he seeks to justify further significant tightening in next week's Budget.

"Monetary stability" should be understood to involve a stable price level or very low rate of inflation over the long run coupled with avoidance of credit boom / bust cycles, which inflict major damage on economic performance. The two objectives are intertwined: historically, credit cycles have invariably been associated with significant and sustained price disturbances.

The Chancellor's plan, therefore, to separate responsibilities for inflation and credit control between two policy-making bodies is questionable. It would have been preferable to assign new "macroprudential" policy tools to the Monetary Policy Commitee (MPC) while expanding its remit to include leaning against major swings in money and credit expansion.

The interest rates faced by borrowers and savers play a key role in the transmission of policy changes to financial market conditions and inflation. One way of thinking about the new arrangements is that the MPC will set the risk-free rate while the Financial Policy Committee (FPC) will influence spreads by varying capital and liquidity requirements. The MPC's judgement, however, about the level of borrowing / saving rates needed to meet the inflation target may differ from the FPC's assessment based on its stability goals.

The FPC, presumably, would have leant against credit expansion during the 2005-07 boom, resulting in higher borrowing spreads and slower economic growth. Based on the MPC's forecasts at the time, however, this would have pushed prospective inflation below target, requiring the Committee to set a lower level of Bank rate, thereby undermining the FPC's attempt at credit restraint. Would the FPC have responded by requiring a further increase in capital / liquidity buffers?

The preferred alternative of adding credit stability to the MPC's responsibilities would have allowed such tensions to be resolved within a single policy-making body. The Chancellor, moreover, could have taken the opportunity to change the MPC's target from 2% inflation "at all times" to a 2% per annum average rise in the price level over the long run. This would allow larger short-term inflation fluctuations to accommodate temporary conflicts with the credit control objective while requiring the MPC to correct under- or overshoots, thereby providing a firmer anchor for long-run expectations than current arrangements (under which the Committee is able to tolerate a persistent deviation while claiming to be adhering to its remit).

The May Royal Institute of Chartered Surveyors (RICS) survey signals a rebound in housing market turnover following weakness related to the ending of the previous stamp duty holiday (since extended) and the election. The net percentage of agents expecting an increase in sales rose to an eleven-month high, probably presaging a pick-up in mortgage approvals – see first chart.

Despite a recent increase in sales instructions, stock levels are the lowest since November. The new buyer enquiries and prices balances remain positive, the latter at levels historically consistent with solid gains – second chart.

At least until official interest rates rise significantly, real house prices may continue to follow the pattern of the early 1980s recovery, implying increases of 4% and 7% (Nationwide measure) respectively in the years to the fourth quarters of 2010 and 2011 – see third chart and previous post for more discussion. Assuming, conservatively, 3% retail price inflation, this would entail nominal growth of 7% and 10%, resulting in prices regaining their 2007 peak by late 2011.

Such a scenario could be upset by harsher tax treatment of housing but the coalition will be brave to grasp this nettle – the consensus is that any rise in capital gains tax on second homes and buy-to-let investments in next week's Budget will be vitiated by generous taper relief.

The fall in consumer price inflation to an annual 3.4% in May from 3.7% in April was in line with a projected path presented graphically in a post a month ago and partly reflected favourable base effects, as well as a seasonally-unusual decline in unprocessed food prices.

The projection has been updated to take account of a recent easing of petrol prices and now shows the headline rate moving down to 2.9% by July, implying no further explanatory letter that month. It remains, however, well above the 2% target during the second half and rebounds in 2011, based on a firming of core price trends as the recovery develops and an assumed rise in the standard VAT rate to 20% in January – see first chart.

Tax changes aside, risks to this forecast are weighted to the upside since it assumes a significant near-term slowdown in core inflation that is at odds with rising price expectations in business and consumer surveys – second chart.

Geek's note: the CPI at constant tax rates (CPI-CT) rose by only 1.6% in the year to May but this should not be used as an estimate of the hypothetical rate of inflation in the absence of this year's VAT hike because the calculation assumes full pass-through of changes. Based, more realistically, on 50% pass-through, CPI inflation would currently stand at 2.5% if tax rates had been constant over the last 12 months (i.e. the mean of the headline rate of 3.4% and CPI-CT rate of 1.6%).