The surprisingly dovish February Inflation Report suggested a shift in the Bank of England's priorities towards supporting growth in the face of coming fiscal tightening rather than achieving its formal remit target of a 2% annual CPI increase "at all times". The Bank, of course, justified its stance by projecting a future fall in inflation but its forecasts have little credibility, having been overshot persistently in recent years.

Markets, it appears, agree that the Bank's inflation-fighting commitment has softened. The yield gap between conventional and index-linked gilts of between five and 15 years' maturity – a proxy for long-term market inflation expectations – has risen steadily from a short-term low the day after the Inflation Report, yesterday reaching its highest level since October 2008. US market-implied inflation expectations are little changed over the same period  – see first chart.

Sterling, meanwhile, has fallen by 4% both against the US dollar and in trade-weighted terms since the Report. Coupled with renewed strength in dollar commodity prices, this has resulted in an 11% surge in industrial raw material costs, as measured by the Journal of Commerce index in sterling terms – second chart. Input costs are 60% higher than a year ago.

The Bank is now in a bind. Markets are rebelling against its dovish shift and their reaction further increases the risk of a sustained inflation overshoot, warranting consideration of an early Bank rate hike. This would be highly contentious given the imminent election and weather-depressed economic reports but policy inaction could result in an extension of recent market moves, ultimately forcing the Bank's hand.

The view expressed in prior posts that the global economic recovery will be sustained through 2010 rests on improvements in corporate liquidity feeding through to a pick-up in business investment and hiring, with rising employment supporting consumer incomes and spending. Recent US and UK evidence is consistent with firming labour demand.

In the US, non-farm payrolls fell by 171,000 in the three months to February but last month's number was depressed by snow storms that prevented some existing employees and new hires from turning up for work. An alternative payrolls measure based on households' assessment of their employment status is likely to have been less distorted by weather effects and rose by 292,000 over the last three months – see first chart. A catch-up gain in headline payrolls is possible this month.

Leading indicators have improved further: a measure based on the ISM manufacturing employment index, the NFIB small firm hiring plans index and the Challenger-Gray-Christmas lay-offs tally has risen to a level historically consistent with three-month payrolls growth of between 250,000 and 500,000 – second chart.

In the UK, job vacancies rose by a surprisingly-strong 11% in the three months to January from the prior three months, a pick-up confirmed by the Market jobs survey – third chart. Vacancies correlate with GDP so this suggests that underlying economic momentum, abstracting from weather effects, strengthened around year-end – final chart.

Current low monetary growth will not prevent inflation overshooting the 2% target because the velocity of circulation of money is rising fast in response to negative real interest rates. The Bank of England should raise interest rates to stem the fall in the demand to hold money and slow the pick-up in velocity.

Nominal GDP rose at an annualised rate of 3.9% during the second half of 2009 while the broad money supply – as measured by M4 excluding money holdings of non-bank financial intermediaries – fell by an annualised 1.2%. The velocity of circulation of money, therefore, increased by an annualised 5.1% – the largest two-quarter gain since 1999.

The velocity rise is the counterpart of a reduction in the demand to hold money by households and financial institutions, driven partly by a recovery in confidence but more importantly by the negative post-tax real return on bank deposits, which is encouraging a rebalancing of portfolios. Record mutual fund inflows are evidence of this portfolio shift: retail investors bought a net £1.8 billion of unit trusts and OEICs in January, bringing the 12-month running total to £26.4 billion, equivalent to 2.7% of household money holdings, according to Investment Management Association figures released yesterday – see chart.

Post-tax real interest rates were last negative for a sustained period in the 1970s. M4 velocity rose at an average annualised rate of 4.7% over 1974-79.

The 2% inflation target is consistent with nominal GDP growth of 4-5% per annum over the medium term, assuming trend real economic expansion of about 2.5% pa. If velocity were to continue to rise by about 5% pa, this would imply no room for any increase in the money supply. A policy of expanding asset purchases to achieve a positive rate of monetary growth would be misguided, leading to an inflation overshoot.

M4 excluding intermediaries’ money holdings rose by an annualised 1.9% in the three months to January. On current velocity trends, therefore, money growth may already be too strong to achieve the 2% inflation target. Rather than expanding asset purchases, the Bank of England should be considering raising interest rates to stem the flow of funds out of bank deposits and restrain the pick-up in velocity.

UK government debt has a longer average maturity than the international norm. Official figures, however, overstate the advantage because they fail to account for the "maturity transformation" implied by the Bank of England's gilt-buying.

According to the Debt Management Office (DMO), the average maturity of gilts and Treasury bills outstanding was 13.5 years at the end of 2009. This figure, however, includes £190 billion of gilts bought by the Bank of England, representing 23% of the stock of debt held outside the DMO.

The market has, in effect, exchanged these gilts, with an average maturity of about 10 years, for central bank reserves, which are repayable on demand. The relevant metric for assessing refinancing risk is the average maturity of the market's combined holdings of debt and reserves, not that of the stock of debt including the Bank's gilts. This is significantly lower, at about 11 years, down from 14 years in mid 2008 – see chart.

The Bank of England pays Bank rate on reserves. This results in an interest saving when Bank rate is below the initial yield on purchased gilts, as at present. The Bank, however, might be forced to tighten monetary policy aggressively in the event of a funding or exchange rate crisis. This would be instantly reflected in the combined government / Bank interest bill.

The UK's "true" debt maturity is still significantly longer than for other major countries – the US is at the low end of the range, with an average maturity of publicly-held marketable debt, including bills, of about four years. The gap, however, is much smaller than a year ago and would erode further if the Bank were to extend its gilt-buying programme.

An ICM poll published over the weekend reported a rise in the Conservative lead over Labour to nine percentage points from seven points in mid February, against the recent trend. This has not been confirmed by other pollsters – BPIX reported a further narrowing to just two points – but is consistent with the prediction of the economic polling model discussed in prior posts, beginning in December.

In this model, the governing party’s poll position relative to the main opposition depends positively on wage and house price growth and negatively on inflation, unemployment and interest rate changes. The model predicted a big narrowing of the poll gap in late 2009 and early 2010 but has been suggesting that the Conservatives would pull ahead again into the spring, mainly reflecting the negative impact of higher inflation on Labour’s popularity. A caveat, however, was that voters might blame the Bank of England rather than the government for faster price rises.

The approach, of course, can be criticised as reductionist and the model’s historical fit is far from perfect. It will, however, be interesting to monitor poll developments against its forecast of a widening of the Conservative / Labour lead to 11-12 percentage points in May (based on a rise in retail price inflation to 4.5% by March and stability of the other inputs).

If the model is to be believed, a Conservative majority is likely and Labour will rue not calling an early March election.

Irish 10-year gilts are currently trading on a yield spread of 150 basis points (bp) over Bunds, down from a peak of 270 bp a year ago and compared with 300 bp for Greek bonds. This seems modest compensation for the financial risks. Irish and Greek spreads were similar as recently as November.

Ireland gained plaudits for a tough December Budget that cut the projected 2010 general government deficit from 13.5% of GDP to 11.6%. Following the further measures announced this week, however, Greek plans are more ambitious, targeting a budget shortfall of 8.7% of GDP this year.

Ireland’s stability programme envisages a decline in the deficit to 2.9% of GDP by 2014, a reduction of 8.7 percentage points over four years. This looks impressive but assumes €5.5 billion of unspecified future fiscal retrenchment. On current policies, the 2014 deficit would be 5.6% of GDP.  This compares with UK general government borrowing of 4.6% of GDP in 2014-15 projected in December’s Pre-Budget Report.

Within general government, the Exchequer or central government deficit is projected to decline by 26% in 2010. The shortfall in January and February, however, was 15% higher than a year before. Current spending fell by 5% but current receipts were down by 18%. Ireland is lagging the global recovery – the OECD’s leading index is up by 3% over the last 12 months compared with gains of 10% and 9% for its Eurozone and UK indices. With the UK accounting for more than a fifth of trade, recent sterling weakness against the euro is unwelcome.

Ireland’s banking system is critically dependent on ECB life support. Central Bank of Ireland lending to banks was €98 billion at the end of January, the equivalent of 60% of annual GDP. This represents 13% of total Eurosystem lending to banks compared with Ireland's 2% share of Eurozone GDP. The Bank of Greece's lending to banks amounts to 20% of Greek GDP while numbers for Spain and Portugal are much lower – see previous post.

A renewal of market worries about Ireland would be expected to be reflected in a withdrawal of funds from its banking system, necessitating increased ECB support. Irish central bank lending is down from a peak of €130 billion in June 2009 but rose in December and January. This bears monitoring: an increase in lending in mid 2008 preceded a sharp rise in the Irish / German yield spread – see chart.