Two Group of Seven (G7) countries have released April industrial output figures: the US registered a 0.5% decline and Japan a 5.2% gain – see first chart. The Japanese rise dominates and suggests a small increase in G7-wide output in April barring significant weakness in European data due in a fortnight's time.

G7 output peaked in February 2008. A bottom in March 2009 would imply a 13-month recession, similar to the duration of the 1974-75 and 2000-01 downturns (12 and 11 months respectively) – second chart. The recent fall, of course, has been much larger, with a 19% peak-to-trough drop versus 12% in 1974-75 and 7% in 2000-01.

A post last December predicted a G7 output bottom in March based on a pick-up in inflation-adjusted narrow money M1. Real M1 is showing very strong annual growth, supporting near-term economic recovery hopes – third chart. It has, however, slowed over the last three months – further weakness could signal a loss of economic momentum in late 2009.

With a 0.1% fall in consumer prices in the year to May, Germany becomes the fourth Group of Seven (G7) country to record headline "deflation", following the US, Japan and the UK (the latter based charitably on the retail prices index, which incorporates declines in mortgage rates and house prices, as well as the December VAT cut).

G7-wide consumer prices were down an annual 0.3% in April. The fall reflects a collapse in commodity prices from their levels a year ago – see chart. The rate of change of "core" CPI – excluding food and energy – remains positive in every country bar Japan, averaging an annual 1.5%. As the chart shows, the commodity price effect will reverse in late 2009, assuming no renewed decline from current levels.

Headline inflation should therefore converge on core. Core inflation should decline in 2009-10 as global excess capacity undermines pricing power. After the last recession it fell to an annual 1.0%. Headline G7 inflation could rebound to around this level in early 2010 – higher if commodity prices continue to rally.

Deflation, like inflation, is a monetary phenomenon. The global money supply continues to grow healthily, arguing against a sustained period of falling prices.

UK house prices are no longer expensive relative to a measure of "fair value" based on rents. Prices fell significantly below fair value during the major house price busts in the 1970s and 1990s but a big undershoot is unlikely in the current downturn because low interest rates will limit forced selling.

The notion that housing is no longer overvalued is controversial because the house price to income ratio remains far above its average since 1965 – see first chart. This average, however, is unlikely to be a good guide to fair value because the ratio has trended higher over time, reflecting factors such as improving quality, the pressure of an expanding population on constrained supply and a high income elasticity of demand for housing.

An alternative approach is to use rents rather than income as the basis of comparison. Rents already incorporate fundamental influences on housing demand and supply. People need to live somewhere – the choice is between buying your own home or renting, not between spending money on housing or retaining income for other purposes.

An economy-wide rental yield can be calculated from national accounts data by dividing the sum of actual rental payments and imputed rents of owner-occupiers by the value of the housing stock – second chart. The yield averaged 3.6% between 1965 and 2007. This seems low but the measure includes subsidised social housing and takes account of vacant properties.

The housing boom pushed the rental yield down to 2.8% at the end of 2007, suggesting that prices were then overvalued by about 29%, based on the 3.6% long-run average. The Halifax index has fallen by 21% since December 2007, while rents had grown 6% by the fourth quarter of last year. These changes imply a current yield of about 3.8%, consistent with small undervaluation.

The rental yield rose well above the 3.6% long-run average during prior housing busts. If the overshoot in the current downturn were to equal the undershoot during the boom, the yield would rise to 4.4%. This would be consistent with a further fall in prices of about 14%, assuming unchanged rents. A decline of this order is widely expected.

Such a scenario, however, is probably too pessimistic. A key difference from prior busts is the low level of mortgage interest rates, which is allowing many struggling borrowers to continue to service their loans. The Council of Mortgage Lenders last week reported that repossessions and arrears cases rose by less than feared in the first quarter. The CML intends to revise down its earlier forecast of 75,000 repossessions in 2009.

With less distressed selling, downward pressure on prices from rising supply is much smaller than in prior downturns. According to the Royal Institute of Chartered Surveyors, the number of unsold homes on the books of the average estate agent stood at 69 in April – far below peaks of 166 and 196 in the last two major housing downturns. Meanwhile, buyer enquiries have picked up recently.

Translating buyer interest into transactions depends critically on mortgage availability. The last Bank of England credit conditions survey reported tighter mortgage supply in early 2009 but expectations of an improvement in the spring. Signs of a stabilisation of prices could have a self-reinforcing effect by encouraging lenders to reduce current high deposit requirements, designed partly to protect against negative equity.

Of course, if house prices bottom at a smaller discount to fair value than in previous downturns, this also implies less scope for a significant recovery over the medium term. Moreover, an increase in supply may have been postponed rather than cancelled – "zombie" borrowers will have their life support turned off once the MPC starts raising interest rates.

A monthly GDP estimate derived from data on services and industrial output fell by 0.2% between February and March, the smallest decline since October – see chart. The slower pace of contraction is consistent with better purchasing managers' survey results in March; PMI readings continued to improve in April.

The monthly estimate was 0.3% below its first-quarter average level in March, suggesting that second-quarter GDP figures – released in late July – will show a further decline. Based on current PMI readings, however, this could be smaller than the 0.6% fall implied by the Bank of England's latest Inflation Report forecast. The Bank is projecting a further contraction of 0.3-0.4% in the third quarter.

Today's numbers confirm a 1.9% GDP fall between the fourth and first quarters, with the expenditure breakdown showing broad-based weakness. A silver lining, however, is that destocking rose further to reach 2.0% of the level of GDP – the highest on record in quarterly data going back to 1955. A slowdown in stock liquidation will provide important support to the economy later in 2009.

Provisional April monetary statistics released today do not include new information on the MPC's favoured broad money aggregate – M4 excluding deposits of "intermediate other financial corporations". On the basis of the data provided, however, this measure is likely to have grown moderately last month.

Headline M4 rose by just 0.1% in April but the release notes a negative impact from a fall in repos with "other financial corporations". To the extent that this decline reflected transactions with financial intermediaries, it will not affect the MPC's adjusted M4 measure. Without the repo change, M4 would have grown by 0.5% last month, or about 6% annualised.

The Bank of England's gilt purchases were reflected in a large public sector contribution to M4 growth in April – "net sterling lending to the public sector" amounted to £30 billion or 1.5% of M4. This boost, however, was partly offset by weakness in private sector sterling credit and a large fall in "net other assets".

Overall, the figures – while incomplete – are slightly disappointing and support the MPC's decision to expand the QE programme.

Today's Financial Times draws attention to the huge deterioration in the UK's relative inflation performance caused by last year's plunge in the exchange rate, a topic discussed in an earlier post. Its observations, however, should be qualified in two respects.

First, the FT uses the CPI excluding indirect taxes as a gauge of "true" inflation, i.e. adjusting for the impact of December's VAT cut. This rose an annual 3.8% in April versus a 2.3% increase in the headline CPI. A better measure, however, is the CPI at constant tax rates (CPI-CT), which climbed by a smaller 3.4%.

Moreover, both of these alternative indices are based on the assumption that the VAT reduction was passed on in full – highly unlikely. Using a more realistic estimate of 50% pass-through, "true" inflation in April was 2.8-2.9% (i.e. halfway between the headline 2.3% and 3.4% CPI-CT increases).

Secondly, as discussed in a post last week, recent sterling strength – if sustained – promises a reduction in imported inflationary pressures later in 2009. The MPC's central-case forecast that the annual CPI increase will slow to 0.4% by the fourth quarter looks much too optimistic but the gap between UK and US / Eurozone inflation is peaking and should narrow significantly.

For the gilt market, supply is likely to represent a greater threat than relatively high UK inflation. The stock of gilts in market hands should shrink by about £50 billion over March-July, with Bank of England purchases of £120 billion offsetting net issuance of £70 billion. If the MPC were to suspend QE purchases from August, however, the market would need to absorb supply of £130-135 billion in the final eight months of 2009-10. (The DMO plans to issue a net £203 billion this fiscal year, based on the Treasury's forecast of public net borrowing of £175 billion.)

In other news today, minutes of this month's MPC meeting show that that some members favoured expanding QE by £75 billion rather than £50 billion, while the Committee discussed writing a letter to the Chancellor requesting an increase in the £150 billion limit "should economic conditions require it". This is likely to fuel expectations that gilt-buying will be extended beyond early August but such a decision will depend importantly on forthcoming monetary data (provisional April broad money numbers are released tomorrow).

Meanwhile, Inflation Report forecast tables show that the MPC expects annual average GDP changes of -4.0% in 2009, 1.1% in 2010 and 2.7% in 2011 in its central case based on market interest rate assumptions. However, its mean projections – taking into account a negative risk skew – are much weaker, at -4.2%, -0.2% and 1.6% respectively. This looks excessively gloomy – see last post.