UK consumer price inflation firmed to 2.8% in February and the forecast here remains that it will reach more than 3.5% by mid-2013 before subsiding modestly during the second half, remaining above the 3% letter-writing threshold – the first chart shows an illustrative profile.

The February rise from 2.7% in January was due to energy and unprocessed food – the annual increase in the remainder of the index slowed from 2.6% to 2.5%. This “core” fall, however, should more than reverse into mid-2013, partly reflecting unusually low monthly increases last year dropping out of the calculation. Energy and food prices, meanwhile, should exert additional upward pressure, with unfavourable base effects again contributing (i.e. price declines for motor fuel and household energy in spring 2012).

The forecast of a further significant pick-up is consistent with a measure of inflation expectations derived from the EU Commission monthly consumer survey. This measure leads actual inflation and reached a 16-month high in February – second chart.

In other news today, annual growth in turnover in services industries rebounded from 2.1% in December to 6.6% in January – the highest since February 2012. This suggests that services output recovered from a December fall and increases the probability that the sector will contribute positively to first-quarter GDP. (January output will be released on 28 March.)

Recent data confirm a stronger US economy in early 2013. The six-month change in industrial output, for example, rose to 2.6% (not annualised) in February – a 12-month high and up from a low of -0.3% in October 2012*.

This pick-up, as usual, was foreshadowed by monetary trends. The six-month change in real narrow money rose from a low of 4.1% in March 2012 to 7.3% in October – see chart. Allowing for the usual half-year lead, this suggested that the six-month output change would bottom around September and rise into spring 2013.

Six-month real narrow money growth, however, has fallen sharply from 7.2% in December 2012 to 4.6% in February. This is solid by historical standards but a further decline is likely in March, as a 1.3% monthly rise in September drops out of the calculation. The March reading may fall below the early 2012 low of 4.1%.

Broad money is a less reliable economic predictor but six-month growth of real M2+** similarly fell from 3.1% in December 2012 to 1.8% in February – see chart.

Why is money growth slowing despite ongoing Fed largesse? Narrow money is regarded here as an indicator of spending intentions – consumers and firms are likely to shift funds into demand deposits before increasing outlays. The recent slowdown may reflect increased caution prompted by fiscal tightening and higher energy prices.

The US economy should retain solid momentum into mid-year, reflecting earlier monetary strength, but second-half risks are rising.

*October was affected by Hurricane Sandy; the second lowest reading was zero in August.

**Defined here as M2 plus large time deposits and institutional money funds.

Bank reserves at the Bank of Japan (BoJ) have fallen since the start of the year despite ongoing securities buying under the asset purchase program (APP). This could suggest that the BoJ under outgoing Governor Shirakawa has been fighting a rearguard action against government pressure for monetary activism by sterilising its QE operations – or, indeed, over-sterilising. On closer inspection, however, the fall in bank reserves appears to reflect a seasonal rise in government cash at the BoJ – reserves should rebound as this increase reverses.

The first chart shows BoJ total assets / liabilities and bank reserves, along with projections for 2013 based on current APP plans and an assumption that other balance sheet items are unchanged at end-2012 levels. Assets are tracking the projection: year-to-date APP securities purchases of ¥7.9 trillion by 10 March are consistent with the first-half target of ¥18.4 trillion, while changes in other holdings / loans have been offsetting.

Why, then, are bank reserves undershooting – by ¥13.1 trillion currently? The answer is that the government has increased its lending to the BoJ significantly since the start of the year. Other things being equal, a rise in government cash at the BoJ implies a withdrawal of funds from the rest of the economy, reflected in a fall in bank reserves. Government deposits at the BoJ plus lending under repurchase agreements rose by ¥15.2 trillion between end-2012 and 10 March.

This rise in government cash appears to reflect seasonal factors rather than any policy decision – lending to the BoJ expanded similarly in the first three months of the last three years, as the second chart shows. The seasonal pattern suggests that the recent increase will reverse sharply in late March / April, in which case bank reserves should reconnect with the projection. Such a rebound in reserves would coincide with the arrival of new Governor Kuroda and could be misconstrued as signalling a further BoJ policy shift.

Quoted bank interest rates on mortgages and household savings products were mostly lower again in February, partly reflecting the continuing impact of the Funding for Lending Scheme (FLS). Falling bank rates and exchange rate weakness are delivering a further loosening of monetary conditions when money growth is at a five-year high, arguing strongly against more QE.

Since June 2012, before the July announcement of the introduction of the FLS, the average quoted rate on a two-year fixed-rate mortgage at a 75% loan-to-value ratio (LTV) has fallen from 3.74% to 2.87%, a decline of 87 basis points (bp). 90% LTV mortgages have cheapened by 112 bp over the same period, while the interest rate on two-year fixed-rate savings bonds has dropped by 100 bp – see chart.

Declines in advertised rates on new variable-rate products have been smaller but still significant: two-year 75% LTV mortgages have cheapened by 49 bp since June, while the average rate on instant-access deposits including a bonus has fallen by 52 bp.

Lower funding costs, however, have yet to filter through to existing borrowers on standard variable rates – the average SVR has risen from 4.22% to 4.40% since June. This suggests that banks are cutting interest rates on new mortgages in order to generate enough demand to keep their loan books stable – necessary to obtain FLS funding on the cheapest terms – while widening margins on their business with “trapped” SVR borrowers.

In other UK news, industrial production fell by 1.2% in January, reversing a 1.1% December gain. Bad weather is likely to have played a role and, even assuming no rebound, the implied drag on first-quarter GDP is tiny – January production was 0.5% lower than the fourth quarter average while industry accounts for only 15% of whole-economy output, giving a negative GDP impact of 0.075%. There is currently no hard data on early 2013 performance of the services sector, which will drive the first-quarter GDP result*.

*At the risk of repetition, non-oil GDP adjusted for the Olympics rose in the fourth quarter so a first-quarter decline would not imply a “double dip” in the onshore economy. As previously discussed, an earlier onshore double dip was revised away in GDP figures released last month.

Monetary trends and leading indicators continue to suggest a slowdown in global economic growth from a peak to be reached in the second quarter.

After a small rise in January, global six-month real narrow money expansion is estimated to have fallen again in February, based on monetary data covering 60% of the G7 plus emerging E7 aggregate – see first chart. Real money growth remains respectable by historical standards but has declined significantly from an October 2012 peak, suggesting a slowdown in economic momentum from spring 2013, allowing for the usual half-year lead.

The February decline in the global money measure owed much to China, where real M1 expansion more than reversed a sharp rise in January  – second chart. A previous post argued for caution in interpreting strong January money and credit data because of a probable upward distortion from the late timing of the Chinese New Year. The February results suggest moderate Chinese economic growth.

Meanwhile, a global leading indicator derived from OECD data rose at a slower pace in January, consistent with it reaching a peak in February or March – third chart. A longer-range “double-lead” measure remains below a high reached in October 2012, though has yet to fall significantly. These signals are consistent with the message from monetary trends, i.e. further near-term strength in coincident economic data but some cooling into the summer.

Global growth peaks in recent years have coincided with a transition from "risk-on" to "risk-off" market behaviour. Note, however, that global real money continues to outpace industrial output by a wide margin – sustained bear markets rarely occur against a backdrop of “excess” liquidity, as documented in previous posts, e.g. here.

Credit market borrowing by US non-financial corporations – encompassing securities issuance and direct loans from banks and others – surged to $901.9 billion at an annualised rate in the fourth quarter of 2012, according to the Fed’s flow of funds accounts. Borrowing was the equivalent of 5.7% of GDP – the highest such proportion since 2007. Bond issuance accounted for $782.0 billion, or a record 4.9% of GDP.

Similar surges in borrowing in the late 1990s and mid 2000s occurred ahead of a significant widening of the yield spread between lower-rated corporate bonds and Treasuries – see first chart.

High borrowing, however, need not imply deteriorating financial health. Bond-holders should worry when fund-raising reflects insufficient internal cash generation, or is used to retire equity. This was the case in the two prior episodes – the corporate “financing gap” between investment and retained profits was large, while the sum of equity buy-backs and cash take-overs far exceeded new issuance.

By contrast, the corporate financial balance is currently in small surplus, i.e. net free cash flow is positive. Above-average equity retirement* is contributing to high credit market borrowing but, in addition, corporations appear to be taking advantage of low bond yields to accumulate financial assets and replace other liabilities.

A superior gauge of economic / financial risk, therefore, is total net borrowing, i.e. the difference between changes in non-equity liabilities and financial assets**. This was 2.3% of GDP in the fourth quarter – far below peaks of 6.8% and 9.2% respectively reached in 1998 and 2007.

Total net borrowing is a more reliable leading indicator of the corporate / Treasury yield spread than the credit market component – second chart. The rising trend in net borrowing suggests that the spread will drift higher in 2013-14 but a dramatic widening is unlikely.

*Equal to 2.7% of GDP in the fourth quarter versus an average since 1985 of 1.8%.

**Calculated here as the sum of the financing gap and net equity retirement.