A weighted average of services and industrial output rose by 1.2% in January, more than offsetting December's 0.8% weather-driven fall – see first chart. The January level of output was equal to September's recovery high and 0.7% above the fourth-quarter average.

Overall GDP, however, was depressed by a surprise further 9% fall in construction output in January following a 16% December plunge. GDP is estimated to have increased by only 0.6% after a 1.8% fall in December to stand 0.5% below its fourth-quarter average – first chart

Fortunately, construction weakness probably reflects carry-over from December's bad weather disruption and output should recover strongly over coming months. Consistent with this view, construction orders, which lead output and softened in the middle of 2010, rebounded to a new recovery high in the fourth quarter – second chart.

The EU Commission's UK business surveys for March are encouraging, showing significant rises in confidence across the services, industrial and retail sectors, in the former two cases to new recovery highs. Employment expectations, in particular, strengthened impressively, confirming an improvement in labour demand signalled by rising online job vacancies – see third chart and previous post.

Gilt yields have been suppressed by strong demand from banks and building societies, which bought a further £7.7 billion in February following £10.5 billion in January, according to monetary statistics released today. Purchases totalled £29.6 billion between November and February, more than in the first 10 months of 2010 and equivalent to 84% of net gilt issuance – see chart.

Banks are buying gilts partly under regulatory pressure but also because private sector demand for bank loans remains weak. Any revival in credit demand would probably slow the rate of purchases and put upward pressure on gilt yields. For the moment, banks are effectively delivering the QE2 stimulus sought by MPC arch-dove Adam Posen.

Increased bank demand for gilts has offset a recent slowdown in overseas buying, which was boosted last year by capital flight from peripheral Eurozone economies. Foreign investors purchased £3.5 billion of gilts in February and £13.2 billion in the last four months, down from £67.6 billion between January and October 2010. The Portugese debt crisis should support overseas gilt demand near term.

Other features of today's monetary and revised GDP data include:

• The Bank of England's favoured broad money measure, M4 excluding money holdings of "intermediate other financial corporations", fell by 0.5% in February, causing three-month growth to slump to 0.5% annualised from 3.2% in January. The February decline, however, was the result of money-holders switching into foreign currency deposits (not included in M4ex), possibly in anticipation of sterling weakness. Foreign currency deposits, excluding holdings of intermediate OFCs, rose by £11.8 billion in February, equivalent to 0.8% of M4ex.

• Ignoring the foreign currency distortion, M4ex rose by 2.2% annualised in the six months to February, up from 1.6% in the prior six months. While growth remains sluggish, it is probably more than sufficient to finance trend economic expansion and 2% inflation given a rise in the velocity of circulation. Nominal domestic demand grew by 6.2% in the year to the fourth quarter despite M4ex expansion of only 1.8%. The Bank of England has recently acknowledged arguments for expecting velocity to continue to increase (see a box in the February Inflation Report and an article in the latest Quarterly Bulletin), implying that an acceptable M4ex growth rate may now be well below the minimum 5% previously suggested.

• M4ex growth of 2.2% annualised in the six months to February compares favourably with Eurozone M3 expansion of 0.6% over the same period.

• With the decline in GDP in the fourth quarter revised back to 0.5% from 0.6%, the Office for National Statistics now estimates that underlying output (i.e. excluding the impact of December's bad weather disruption) was "broadly flat" versus last month's assessment of a "slight fall". Based on labour market and survey data, further upgrades are likely. Note that GDP growth in the fourth quarter of 2009 has been revised up from an originally-reported 0.1% to 0.4%.



Global monetary developments are signalling a prospective slowdown in economic growth and less favourable liquidity conditions for markets. The recovery in the Dow Industrials index since March 2009 continues to display a remarkable resemblance to the rally following the 1906-07 "bankers' panic" bear market, a comparison also suggesting a need for caution.

Six-month growth of G7 real narrow money has slowed progressively from a peak in July, reaching an 11-month low in February – see first chart. The money supply usually leads economic activity by between six months and a year. The last trough in six-month real money growth in January 2010 preceded a low in six-month industrial output expansion 10 months later, in November. Assuming the same lead-time from the recent peak, industrial output should begin to slow from April. Business surveys should soon start to signal this shift.

In addition to the money supply leading economic activity, the gap between real money growth and industrial output expansion is a gauge of "excess" liquidity available to flow into markets and push up prices. Global equities, on average, have underperformed cash when real narrow money has risen more slowly than industrial output. Six-month real money growth crossed beneath output expansion in December, with the gap since widening.

Previous posts have compared the recovery in the Dow Industrials index since March 2009 with an average of rises following six prior bear markets when equities fell by about 50%. The Dow stood 6% above this "six-bear average" at Friday's close while the average falls by 8% by the end of 2011 – second chart.

As discussed in a post in June last year, the recovery in the Dow since March 2009 bears the strongest resemblance to the rebound after the January 1906-November 1907 decline. Like the 2007-09 fall, the 1906-07 bear market was associated with a credit bust and financial panic. Both crises climaxed with the failure of a major institution – the Knickerbocker Trust Company in October 1907, Lehman Brothers in September 2008 – and a subsequent decisive rescue effort (co-ordinated by J P Morgan in 1907, before the institution of the Federal Reserve).

The 20% plus rise in the Dow suggested in the June 2010 post on the basis of this comparison has now occurred. US stocks entered another bear phase at the corresponding stage of the post-1907 recovery. A repeat performance would involve an imminent 14% correction in the Dow and a 20% fall by year-end – second chart.

Weakness on this scale is unlikely barring a major shock but less bullish economic news, slower growth in real money than output and the approaching end of QE2 suggest that equities and other risk assets face increasing headwinds.

Eurozone monetary trends continue to weaken, signalling an economic slowdown this spring and summer and casting doubt on the wisdom of the coming official interest rate hike.

The headlines look favourable, with the broader M3 money supply measure rising by 0.5% in February, pushing annual growth up from 1.5% to 2.0%. The trend, however, has deteriorated in recent months, with six-month expansion falling from a peak of 3.5% annualised in August to 1.1% in January and just 0.6% in February.

Narrow money M1, moreover, contracted in the six months to February, by an annualised 0.8% – the first six-month decline since August 2008, when the economy was in freefall.

Recent trends, of course, look much worse in real terms, with consumer price inflation boosted by energy and food price increases.

Real M1 is a good leading indicator of economic activity. It contracted from late 2007 ahead of the onset of the recession in spring 2008 and surged in late 2008 before a GDP recovery from mid-2009 – see first chart. Real M3 has been much less reliable, although the two measures are currently giving an identical message.

M1 comprises currency in circulation and overnight deposits. The ECB provides a geographical decomposition of overnight deposits but not currency. As the second chart shows, real deposit weakness was initially focused on peripheral economies – defined here as Greece, Ireland, Italy, Portugal and Spain – but has now spread to the core. The fall in business expectations in today's Ifo survey for March probably marks the start of a sustained decline.

The Chancellor set out ambitious goals of creating the most competitive tax system in the G20 and making the UK the best place in Europe for business but his ability to deliver on these aims was undercut by a negative reappraisal of the state of the public finances by the Office for Budget Responsibility. Despite an undershoot in 2010-11, the OBR raised its deficit projections for subsequent fiscal years, with the 2015-16 shortfall increasing from 1.0% to 1.5% of GDP, reflecting both lower economic growth and a worse structural position.

Mr Osborne, therefore, was forced to find further savings to finance his priorities: the net cost of the measures announced is just £10 million in 2011-12 and a cumulative £30 million by 2015-16. He managed, nonetheless, to spring some favourable surprises, including a 1 pence per litre cut in fuel duty (costing £1.9 billion in 2011-12), a faster reduction in corporation tax (£425 million in 2011-12 rising to £1.075 billion in 2015-16), reform of the controlled foreign company rules (£840 million by 2015-16) and a further £630 rise in the personal allowance from next year (£1.05 billion in 2012-13). These giveaways were financed by a higher supplementary charge on North Sea oil profits (raising £1.78 billion in 2011-12), another attack on avoidance and evasion (£985 million in 2011-12), switching to CPI indexation of direct taxes from next year (£105 million in 2012-13 rising to £1.08 billion in 2015-16), a reduction in national insurance contracted-out rebates (£640 million in 2012-13) and the introduction of a carbon price floor from 2013-14 (£1.41 billion in 2015-16).

While there is an element of "robbing Peter to pay Peter", the impression is that the Chancellor has played a poor hand skilfully, and the Budget may earn political plaudits. Its short-term macroeconomic impact, however, will be negligible.

The OBR's negative reassessment of fiscal prospects is a direct consequence of the Bank of England's failure to control inflation: the upward revision to the deficit forecasts is due to higher spending that, in turn, "primarly reflects the impact of our higher inflation forecast on social security and debt interest payments". Debt interest is now projected to rise from £43.1 billion in 2010-11 to £66.8 billion in 2015-16, £3.7 billion higher than in November and equivalent to 3.5% of GDP.

Financing plans show net gilt sales of £120.0 billion in 2011-12, only £7.8 billion lower than in 2010-11 despite a projected fall in public sector net borrowing from £145.9 billion to £122 billion. Gilt funding needs have been boosted by the surprise announcement of a £6 billion increase in the foreign exchange reserves. The sum is small but the policy change is interesting, suggesting a desire for greater protection in the event of future sterling weakness.

CPI inflation rose from 4.0% in January to 4.4% in February, above the consensus forecast of 4.2% but in line with the projection made in a post a month ago. The chart presents an updated profile for 2011 and 2012, based on the same assumptions as in the prior post. Inflation is forecast to fluctuate in a 4.2-4.5% range over the summer and autumn before subsiding from late 2011 as base effects turn favourable. It remains well above the 2% target in 2012, however, averaging 2.5%.

Risks to this forecast are judged to lie on the upside. In particular, the assumption that core prices (i.e. excluding energy and unprocessed food) increase at a 2.25-2.5% annualised pace may prove too low, based on recent evidence that inflation expectations are becoming detached from the target. Further increases in energy and food prices, of course, are also possible.

With February's 4.4% outturn projected to be repeated in March, inflation is on course to average 4.2-4.3% in the first quarter – above the Bank of England's forecast of 4.1% in the February Inflation Report.

Doves claim that inflation would be below target but for indirect tax rises and higher food and energy costs. The Office for National Statistics estimates that full pass-through (unlikely) of tax increases would have boosted the CPI by 1.7 percentage points over the last year. Above-average rises in food and energy prices arithmetically account for a further 1.1 percentage points of current inflation.

Subtracting these effects from the 4.4% headline rate to argue that "true" inflation is below 2%, however, is intellectually flawed. Had taxes remained stable and food and energy prices risen more modestly, consumers would have had more cash to spend on other goods and services, the prices of which would have increased correspondingly faster.

The fundamental cause of above-target inflation has been strong growth in nominal demand, in turn reflecting excessively loose monetary conditions. "Gross final expenditure" – domestic consumption and investment spending plus exports – rose by a nominal 7.2% in the year to the fourth quarter of 2010 and would have increased by nearly 8% but for December's bad weather. This compares with average expansion of 5.5% per annum in the first 10 years of the MPC's existence (i.e. between 1998 and 2007).

Recent evidence confirms that the prolonged inflation overshoot is feeding through to longer-term expectations and pay settlements. The median level of settlements in manufacturing and private services was 2.9% in the three months to January, according to Incomes Data Services, a level that, if sustained, suggests a pick-up in private-sector regular earnings growth from an annual 2.1% in January to 3.6% by the end of 2011 – see previous post. Faster labour cost expansion could push core inflation higher in late 2011 and 2012 even as imported inflationary pressures ease.