Gilt yields were suppressed this spring by further semi-compulsory purchases by banks along with a pick-up in foreign buying, probably related to capital flight from the Eurozone as sovereign debt worries mounted.

The Debt Management Office issued £16.1 billion of gilts in May, while UK banks and overseas investors each bought £7.4 billion, with the rump taken up by domestic non-banks. Bank purchases totalled £33.5 billion, or 69% of net issuance, in the six months to May. Overseas buying in May was the strongest since December, in the wake of the Irish bailout – see first chart.

With banks' liquid asset holdings at their highest for nearly 30 years, according to the recent Financial Stability Report, gilts are vulnerable to a slowdown in their buying, as well as reduced foreign purchases if a Greek financial support deal calms Eurozone debt markets.

Other features of today's monetary statistics for May include:

• Broad money (i.e. M4 excluding holdings of intermediate other financial corporations, or M4ex) rose by 0.3% in May, reversing a 0.1% fall in April. Annualised growth was only 1.0% in the latest three months but – as previously discussed – has been depressed by money-holders switching from sterling into foreign currency deposits, possibly in (correct) anticipation of exchange rate weakness. UK residents' currency deposits at UK banks, excluding holdings of intermediate OFCs, increased by the equivalent of 1.0% of M4ex in the three months to May (unadjusted, not annualised).

• Narrow money trends have improved, with M1 rising by 9.7% annualised in the three months to May, following a contraction in late 2010 / early 2011. M1 is a better leading indicator than broad money and more weight should have been given here to its earlier weakness, which signalled recent economic sluggishness. The pick-up since early 2011 suggests improving economic prospects for the second half of the year.
  

• The corporate liquidity ratio – sterling and foreign currency bank deposits of non-financial corporations divided by bank borrowing – recovered in April and May after a first-quarter dip. Excluding property companies, the ratio is at its highest level on record in data extending back to 1998 – second chart.



The forecast of a reacceleration in G7 industrial momentum later this summer – based on faster real money supply growth since early 2011 and an unwind of Japan supply disruptions – is supported by today's Federation of Korean Industries survey for June.

Korean indicators are often early to detect shifts in global momentum, reflecting the economy's orientation towards exports (52% of GDP in 2010) and intermediate goods production. A slump in FKI manufacturing expectations this spring foreshadowed a sharp fall in G7 PMI new orders – see previous post.

Korean expectations recovered modestly in May, maintaining the improvement in June – see chart. This suggests that G7 new orders bottomed in May or, more likely, June.

Today's US Richmond Fed manufacturing survey provides a further hint of revival, with current and expected new orders rising in June, bucking the trend of weakness in earlier surveys from other regions.

The additional 29 April bank holiday has complicated interpretation of recent UK statistics, which have consequently received limited coverage here. Purchasing managers' surveys for June to be released over 1-5 July will provide important guidance about the state of the economy. One hopeful sign is that revisions to analysts' forecasts for company earnings have been balanced over the last month, following net downgrades in May. The PMIs correlate with earnings revisions – see first chart.

Last week's public finance numbers evoked much gloom about fiscal prospects. Borrowing in April and May combined was £1.5 billion higher than a year before but the comparison is distorted by the £3.5 billion bank payroll tax paid in April 2010. A six-month moving average of seasonally-adjusted borrowing continues to decline slowly – second chart. The recent rate of improvement, if sustained, implies a deficit of £125-30 billion in 2011-12, above the OBR's £122 billion forecast but down from £143.2 billion in 2010-11.

A previous post suggested that CPI inflation would undershoot the Bank of England's mean prediction of a rise to 5.0% in the third and fourth quarters of 2011. This prospect has been strengthened by the recent reversal in wholesale energy prices, which should result in a significant decline in motor fuel costs – third chart – while tempering coming utility price rises. The fuel effect is likely to shave 0.2% from the CPI relative to its May level, based on an unleaded price of £1.30 per litre (motor fuel has an index weight of 4.3%).

Recent lower energy prices and stable food prices – if sustained – promise a significant slowdown in G7 headline inflation, which, in turn, would provide a further boost to real money supply expansion, thereby improving global economic prospects for late 2011 / early 2012.

G7 consumer price inflation has risen from 1.3% in October 2010 to 2.8% in April and may have reached 3.0% in May, based on available data (the Japanese CPI for May has yet to be released) – see first chart. Not all of the pick-up has been due to food and energy prices – core inflation has firmed from 0.7% in October to 1.3% by April.

The “wedge” between G7 headline and core inflation is closely correlated with the annual rate of change of the IMF all commodities price index – second chart. If commodity prices were to remain at yesterday’s levels, annual growth in the IMF index would slow from 35% to about 10% by late 2011, suggesting a fall in the headline / core inflation wedge from 1.5 to about 0.5 percentage points.

Core inflation is likely to continue to trend higher, reflecting earlier cost increases passing through the pricing chain and “second-round” effects, as firms and consumers resist erosion of real profits and wages. Assuming a rise to 1.5% by late 2011, a 0.5 percentage point wedge implies a headline G7 inflation rate of 2.0%, about one percentage point lower than currently.

The recent slowdown in global economic growth was signalled by a deceleration of G7 real narrow money expansion in late 2010. The six-month growth rate of real money, however, has moved up from 1.4% in February (not annualised) to 2.1% in April and is likely to have risen further in May, based on US and Japanese monetary data – third chart. Allowing for the normal six-month lead, this suggests that global industrial momentum will revive from the late summer. If so, manufacturing PMI new orders indices should start improving from July or August.

The coming inflation fall promises to sustain the real money pick-up. Six-month G7 real narrow money expansion of 2.1% in April reflected nominal growth of 4.4% and a 2.2% seasonally-adjusted rise in consumer prices. Assuming that commodity prices stabilise at their current level, the G7 CPI could be broadly flat over the next six months. Nominal money growth may slow following the end of US QE2 but not by enough to prevent a further rise in real expansion, in turn suggesting that the coming economic reacceleration will be sustained into early 2012.

Global manufacturing momentum may revive over coming months – see previous post – but not with any help from the Eurozone, where leading indicators look increasingly grim.

The first chart shows six-month growth of Eurozone industrial output together with a forecasting indicator derived from the OECD's leading index. The indicator has been negative for some time but recently took a further turn for the worse. Current weakness looks ominously similar to late 2007 when output was still expanding but a recession loomed.

Shorter-term indicators confirm a significant loss of momentum. The earnings revisions ratio (i.e. the number of upgrades to company earnings forecasts minus downgrades expressed as a proportion of the number of analyst estimates) moved deeper into negative territory in June, reaching its lowest level since July 2009. The ratio correlates closely with the PMI manufacturing new orders index, which may soon slip below the 50 breakeven level – second chart. Of the major economies, Italy posted the weakest reading this month but downgrades are now dominating even in Germany.



During 2009 and 2010 many commentators argued that UK broad money supply growth was too low, implying that the economic recovery would fail and / or inflation would undershoot the target. The counterargument deployed here was the velocity of circulation (i.e. the rate at which the existing stock of broad money turns over) was likely to rise in response to negative real interest rates. (A rise in velocity has the same economic impact as money supply expansion.) Nominal GDP growth, therefore, was more likely to be too strong than too weak.

Sufficient time has elapsed to make a preliminary judgement on this issue and it is unfavourable to the monetary pessimists. From a trough in the second quarter of 2009, nominal GDP rose by 9.1% by the first quarter of 2011 while broad money (i.e. M4 excluding holdings of “intermediate other financial corporations”) grew by 2.4%. The velocity of circulation, therefore, rose by 6.5%, or 3.7% at an annualised rate.

The current disappointing economic environment is the result not of insufficient nominal GDP expansion – the 9.1% increase annualises to a 5.1% growth rate over the seven quarters – but rather an unfavourable split between real activity and inflation.

In his Mansion House speech last week, Bank of England Governor Sir Mervyn King claimed that the recovery in real GDP would have been weaker if the MPC had reduced the degree of monetary policy stimulus in response to evidence that inflation was embarking on a sustained overshoot of the target. This claim is suspect. Less expansionary policy would have lowered the rise in nominal GDP but would probably have resulted in a more favourable activity / inflation split, suggesting real growth little different and possibly higher than actually achieved. A stronger pound resulting from MPC policy action, for example, would have lowered import price inflation, allowing a greater proportion of consumers' budgets to be spent on domestic goods and services.

Sir Mervyn failed even to acknowledge the large increase in velocity since 2009 in his latest speech, in which he again cited slow monetary expansion as a reason for inflation optimism*. The MPC is wrong to ignore the possibility that velocity is now on a rising trend. The chart shows the nominal GDP / broad money ratio since the early 1960s together with official interest rates and a smoothed measure of inflation. Following a similar cross-over of the inflation measure above official rates in the mid 1970s, velocity embarked on an increase of 38.6% over six years (i.e. 5.6% per annum), resuming its long-run downward trend only after positive real interest rates were restored in the early 1980s.

Absent a significant narrowing of the inflation / interest rate gap, velocity is likely to continue to rise, albeit less rapidly than in the 1970s when real rates were more negative than now. Assuming that the 3.7% annualised rate of increase since the second quarter of 2009 is sustained, broad money growth of 1-2% per annum is sufficient to support trend economic expansion and 2% inflation, and may even be too high. Suggestions that the MPC should embark on another round of QE in order to boost monetary growth, therefore, are dangerous – such an initiative would probably entrench or extend the current inflation overshoot, in part by putting renewed downward pressure on sterling as newly-created "excess" money is exported.

* "So far, subdued rates of increase in average earnings, as well as remarkably – some might say disturbingly – low growth rates of broad money have provided strong signals that inflation will fall back in due course." M4 excluding intermediate OFCs rose by 1.5% in the year to April.