Few economists expect a further expansion of QE at this week’s policy-setting meeting but such an outcome is suggested by a model based on the MPC's historical reaction function.

The “MPC-ometer” uses 12 economic and financial indicators to forecast the monthly policy decision and has performed well since its introduction in 2006, except for several months in late 2010 and early 2011 when it predicted modest tightening – such a shift would have tempered the current inflation overshoot. More recently, the model signalled the launch of QE2 last autumn and its extension in February.

The model has maintained a dovish bias in recent months and shifted further in May, consistent with a £75 billion expansion being announced this week. This mainly reflects the 0.2% fall in GDP in the first quarter but declines in the PMIs and consumer confidence, a further slowdown in pay growth and weaker industrial pricing plans also contributed.

The consensus expects unchanged policy partly because the April minutes suggested that the MPC would ignore another GDP fall. This, however, assumed that the decline would reflect a large drop in construction output, with other sectors expanding. GDP excluding construction, in fact, was flat last quarter, questioning the Committee’s assumption of a pick-up in underlying growth.

The minutes also acknowledged a deterioration in the short-term inflation outlook but – as last year demonstrates – such a negative reassessment need not preclude further easing. The Committee still appears inclined to attribute disappointments to temporary “shocks", with the minutes stating that “(T)here was little solid evidence yet that the balance of risks to inflation in the medium term had changed.”

The MPC-ometer’s forecast assumes that the Committee will – as it has in the past – place more weight on activity than inflation indicators. An unchanged decision this week could signal that its reaction function is shifting in response to the prolonged inflation overshoot – the MPC, in other words, may judge that an increased threat of expectations becoming detached from the target has constrained its ability to respond to economic weakness.

The widely-watched ISM manufacturing new orders index – a gauge of industrial momentum – rebounded from February / March falls to reach a 12-month high in April. The index, however, may be in the process of peaking out, based on the following considerations.

First, six-month real narrow money growth has slowed from a peak in October and typically leads economic momentum by about six months. (Real money, however, is still expanding, so does not support the long-standing recession calls of the ECRI, Hussman etc.)

Secondly, the recent pick-up in the ISM measure fits the historical cyclical pattern. This pattern suggests a peak in June followed by a gradual decline during the second half.

Thirdly, a leading indicator derived from the OECD’s US leading index appears to have peaked in January, consistent with a spring ISM top. (A March update of the indicator will be available next week.) 

Fourthly, Korean manufacturing expectations often lead ISM new orders and have softened recently.

The suggestion from monetary trends of a slowdown rather than anything worse is supported by recent retail sales resilience.

Worries, meanwhile, that the labour market is softening are not supported by April data on withheld taxes – a timely but noisy proxy for wage incomes.

UK monetary trends continue to suggest a recovery in economic momentum during the course of 2012, though to an uncertain extent.

Recent economic weakness was signalled by a contraction in real broad and narrow money in late 2010 and early 2011 – see first chart. The preferred broad measure here is non-financial M4, comprising holdings of households and non-financial companies. Its six-month real change reached a low of -2.7% (not annualised) in April 2011 but was recovering before the MPC launched QE in October. Today’s March release shows a further rise to 0.8% – the strongest since early 2009, just ahead of a spurt in growth.

The hopeful message from broad money, however, is clouded by continued weakness in real narrow money M1, although its decline has slowed since early 2011. M1 may have been depressed by banks’ bidding more aggressively for term funding – the spread between the average rates on household time and interest-bearing sight deposits has widened from 1.67% to 1.83% over the last year. The non-interest-bearing component of M1, moreover, is growing solidly. These considerations suggest placing more weight on the broad money signal at present.

A further positive development is a recovery in the corporate liquidity ratio (i.e. sterling plus foreign currency deposits of non-financial companies divided by their bank borrowing) in the first quarter, reversing a decline during the second half of 2011 – second chart.

Note that the traditional M4 broad money measure is currently being distorted by a contraction of interbank financial activity channeled through “intermediate other financial corporations” – such activity is of little relevance to the wider economy, which is why direct interbank business is excluded from money supply definitions. Bearish analysis based on the fall in M4, in other words, should be ignored.