Investors are debating whether recent weakness in industrial commodity prices is the beginning of a lasting move reflecting "fundamentals" or a temporary set-back, possibly due to disruption caused by the Japanese earthquake or a liquidation of QE2-related speculative positions. The balance of evidence seems to favour the former view:

1. Commodity price fluctuations are mostly explained by shifts in industrial demand in emerging economies. The close correlation of six-month changes in prices and E7 industrial output suggests little role for financial speculation – see first chart.

2. QE2 has probably boosted commodity prices but the "transmission mechanism" has been an unwarranted loosening of monetary conditions in emerging economies and resulting excessive industrial expansion rather than direct financial investment.

3. Accordingly, the set-back in commodity prices is evidence that emerging-world economic expansion is slowing, probably as a result of domestic monetary policy tightening designed to offset the inflationary effects of QE2. This fits with recent weaker E7 real money supply growth and a proliferation of earnings downgrades by equity analysts – second chart.

4. The global implications could be benign. Emerging economies have driven a strong global recovery but are overheating and need to slow, implying that developed economies must bear more of the burden of sustaining growth. A fall in commodity prices transfers purchasing power from the emerging world to developed market consumers, aiding the necessary transition.

5. A key risk is that China and other emerging economies declare premature victory over inflation, with policy relaxation leading to renewed overheating and upward pressure on commodity prices.

Growth "rebalancing" between emerging and developed economies suggests a slower overall pace of expansion, consistent with experience at the same stage of the late 1970s upswing – see previous post. For equity investors, the implication could be a further rotation away from materials and energy towards sectors likely to benefit from a recovery in developed economies' terms of trade, including consumer goods, consumer staples, health care – and even financials.

As expected, lower growth in the inflation-adjusted global money supply since last autumn has resulted in a loss of economic momentum and a correction in equities. The economic slowdown, however, seems likely to be contained, suggesting that equities will trade in a range rather than weaken significantly:

• Six-month growth in G7 real narrow money remains positive and, based on US and Japanese data, may have picked up in April, hinting at a rebound in economic momentum later in 2011 – see first chart.

• Commodity prices are coming off the boil as emerging-world industrial expansion slows, promising real income relief for G7 consumers. Current oil prices imply a significant fall in retail petrol costs – second chart.

• A rally in bonds is also offering support to the economy, with lower yields feeding through to mortgage rates – UK five-year fixed rates have fallen back below 4% (75% LTV).

Downside economic risks focus on Euroland and China / emerging markets, where monetary trends remain worrying – see Monday's post and third chart.

Narrow money, M1, is usually the best monetary leading indicator of the economy but broader measures provide corroborating information. In the US, “money of zero maturity” (MZM) – comprising instant-access forms of money* – slowed around year-end but has revived more recently, rising at an 11% annualised pace in the latest 13 weeks. As well as suggesting economic reacceleration, the MZM surge is flashing a warning signal for Treasuries – fourth chart.

* MZM = M1 + savings deposits + money funds.

CPI inflation of 4.5% in April was far above expectations, more than reversing a fall from 4.4% to 4.0% between February and March. The late timing of Easter depressed the March number and boosted April's reading, mainly via a surge in annual inflation of air and sea fares – this should reverse in May. This effect aside, a further fall in food inflation was a favourable surprise but was offset by a pick-up in housing services, reflecting rents and water / sewerage charges.

Overall, the "news" relative to the assumptions embodied in the inflation projection presented in a post last week is limited – any revision will await May figures, which should clarify the Easter effect.

The rise in CPI inflation was not confirmed by the previously-targeted RPIX measure (i.e. RPI excluding mortgage interest costs), which eased from 5.4% to 5.3%. RPIX assigns a lower weight to air and sea fares and a higher weight to car insurance – premium increases are slowing. House prices and council tax, additionally, are exerting a drag on RPIX relative to CPI. RPIX inflation has tended to lead in recent years – see chart.

Relative monetary trends suggest that Eurozone GDP outperformance in the first quarter of 2011 will give way to significant underperformance later in 2011.

Eurozone GDP rose by 0.8% in the first quarter versus 0.4% in the US and 0.5% in the UK, with Japanese figures this week expected to show a contraction. Economic performance reflects monetary trends six to 12 months earlier. In the year to June 2010, real narrow money, M1, rose by 7.7% in Euroland versus 3.5% and 2.7% in the US and Japan respectively.

Monetary indicators, however, have since performed a U-turn. Real M1 rose by 8.4% and 5.0% in the US and Japan in the year to April but by only 0.3% in the Euroland in the year to March (the latest available month). This suggests strong economic growth in the US and Japan in late 2011 while Euroland slows sharply or even contracts.

Within the Eurozone, real M1 deposits fell by 4.2% in peripheral economies (i.e. Greece, Ireland, Italy, Portugal and Spain) in the year to March while rising by 3.4% in the "core" (i.e. Austria, Belgium, France, Germany, Luxembourg and the Netherlands). The contraction in the periphery is on the same scale as occurred before the 2008-09 output slump.

In the core grouping, the annual rise of 3.4% compares with 11.9% in June 2010 while real M1 has declined over the last six months. Eurozone economic weakness later this year, therefore, is likely to reflect a big slowdown in the core, including Germany, as well as stagnation or renewed recession in the periphery.

The chart shows an update of a monthly CPI inflation profile presented in a previous post together with the Bank of England's mean forecast based on unchanged policy, estimated from chart 5.13 of the May Inflation Report. Assumptions underlying the profile include:

• "Core" prices – defined here as the CPI excluding unprocessed food and energy – rise at a 2.25-2.5% annualised rate, in line with an estimate of the trend leading into the recent VAT hike.

• 90% of the VAT rise has been passed onto consumers, consistent with evidence from the Bank of England agents' survey – higher pass-through implies a larger mechanical fall in inflation next year as the impact drops out.

• Household energy bills rise by 7.5% over the next 12 months.

• Unprocessed food inflation peaks at an annual 6% in mid 2011 and slows to 3.5% in 2012.

• Bank rate is raised to 2% next year, contributing to core inflation remaining stable despite a further rise in capacity utilisation as the recovery continues.

• Undergraduate tuition fees add 0.2 percentage points to inflation from late 2012, as discussed in a previous post.

On these assumptions, inflation is projected to peak at 4.6% later this year before falling back below 3% in early 2012. The average between April 2011 and June 2012 is 0.6 percentage points lower than in the Bank's forecast, showing a quarterly peak of more than 5%. The profile, however, is higher from late 2012, with inflation stabilising at about 2.75% versus the Bank's 2.5%.

Reasons for these differences include:

• The Bank's forecast incorporates a larger rise in household energy bills, of about 12.5% rather than 7.5%. The latter takes account of the recent correction in wholesale energy prices and assumes that slower emerging-world growth will relieve upward pressure over the remainder of 2011.

• The Bank assumes lower VAT pass-through of about 75% rather than 90%, despite the evidence from its own agents, resulting in a smaller favourable base effect on inflation in 2012.

• The Bank's lower forecast from late 2012 reflects its view that spare capacity remains significant and will bear down on core inflation, despite limited evidence of such an impact to date. The Bank's medium-term numbers would be closer to 2% if based on the assumption of a rise in Bank rate to 2% in 2012.

While inflation is likely to remain well above the target for the foreseeable future, a significant fall next year should contribute – with rising wage growth and employment – to a rebound in household real income, in turn supporting prospects for consumer spending and GDP expansion.

Japanese bank reserves surged in the wake of the 11 March earthquake / tsunami as the Bank of Japan supplied emergency funds and, later, intervened to suppress the yen. Some investors speculated that the tragedy had triggered a major policy shift and further Japanese liquidity injections would supercharge global markets already boosted by the Fed's QE2 largesse.

These expectations seemed hopeful at the time – see previous post – and the BoJ has duly disappointed. Reserves have fallen back as lending has normalised and f/x intervention has been sterilised. As of today, they were ¥10.7 trillion ($132 billion) below the late March peak and half-way back to the pre-earthquake level – see chart. The liquidity withdrawal is boosting the yen and has probably contributed to recent commodity price weakness.