The rise in consumer price inflation from an annual 1.1% in September to 1.5% in October marks the start of a trend that is likely to carry the headline rate above 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor. Inflation should subside over the remainder of 2010 but is unlikely to fall below the 2% target, as forecast by the Bank of England in the November Inflation Report.

The headline rate continues to be flattered by last December's VAT cut and lower energy prices than a year ago. The Office for National Statistics has estimated an effect on the headline rate from VAT and duty changes of 0.5 percentage points, suggesting that inflation would be 2.0% in October in the absence of the reduction. On the same basis, "core" inflation – excluding energy, food, alcohol and tobacco – might stand at 2.7% rather than the reported 1.8%.

Petrol prices accounted for much of the rise in headline inflation between September and October but there were also significant upward contributions from cars, flights, food, DVDs, computer games and landline telephones.

Inflation has overshot the Bank's forecasts by an embarrassingly large margin this year. The central projection in the May Inflation Report showed the CPI headline rate falling to just 0.4% in the fourth quarter. Further increases in November and December are likely to result in an outturn of 2.0% or higher. The Bank's forecasts have proved too low because it overestimated the impact of economic slack on core price trends while underestimating upward pressure from exchange rate depreciation and global commodity prices. There is little sign that it has learnt from its mistake, with the November Report continuing to place heavy emphasis on "output gapology" while playing down external price risks.

The RPI headline rate moved up from -1.4% to -0.8% between September and October and will rise much more sharply than CPI inflation over the next six months, reflecting house price and mortgage rate base effects. Even assuming house price stabilisation, RPI inflation is likely to reach about 4% by next spring, with higher figures obviously implied by any increase in official interest rates. Governor King last week stated that the Bank intended to "look through the short-term rise in inflation" but there is a risk that sharply higher headline rates will destabilise inflationary expectations in the absence of any policy response.

The charts update previously-presented profiles for CPI and RPI inflation taking into account October data and revised assumptions about energy and food prices. In particular, the 5% cut in household energy tariffs incorporated in the earlier forecast has been removed, in line with Bank's assumption in the latest Inflation Report.

The relationship between the US monetary base – currency in circulation plus bank reserves at the Fed – and the performance of stock markets, commodities and other "risky" assets remains intact. The new high reached by the Dow Industrials last week followed a 9% surge in the base between the end of September and early November – see first chart.

The base contracted in the week to last Wednesday but this is unlikely to mark a change in trend. The Fed is scheduled to buy $500 billion of mortgage-backed and other agency securities by the end of the first quarter. This cash injection will be offset by a further decline in various forms of "emergency" lending, including term auction credit, discount window loans, commercial paper holdings and liquidity swaps with other central banks. These four items, however, currently sum to $172 billion – even in the unlikely event of the total falling to zero, the effect on reserves would be swamped by securities purchases.

The Fed could, in theory, sterilise the impact of its buying on the monetary base by conducting reverse repurchase agreements (repos), involving banks lending excess cash back to the central bank in return for securities. (The Bank of England has effectively sterilised the base effects of its asset purchases since August by cutting its short-term lending to the banking system.) Such an initiative, however, is unlikely before early 2010 and should be signalled in advance to reduce the risk of a large negative market reaction.

Expectations that US liquidity supply will remain ample at least until year-end have been reflected in further capital outflows from the US to Asia in particular. Currency board arrangements in Hong Kong result in a direct impact on the monetary base, which has climbed by 16% since the end of September, providing strong support for the local stock market and Hong-Kong-listed Chinese "H" shares – second chart.

Global industrial output has already recovered half of its loss during the recession. If the rebound were to continue at its recent pace, output would regain its prior peak level by May 2010 – far earlier than expected by the consensus but consistent with the "Zarnowitz rule" that "deep recessions are almost always followed by steep recoveries".

The top line in the first chart shows an index of combined industrial output in the Group of Seven (G7) major economies and seven large emerging economies (henceforth the "E7") – Brazil, Russia, India and China plus Mexico, South Korea and Taiwan. A smoothed path is also plotted, based on fitting log-linear trends to the separate G7 and E7 data since 2000. This path implies a current trend growth rate of global output of 3.5% per annum.

The global output measure peaked in February 2008 and fell by 14% to a trough in February 2009. It had recovered by 7% by September 2009, equivalent to an annualised increase of 13%. If this growth rate were to be sustained, output would regain its 2008 peak level in May 2010 and cross above its trend path in June.

The lower lines show the contributions of G7 and E7 output to the global total, together with associated trends. The outsized impact of emerging economies on global trend growth is immediately apparent. The curvatures of the trends imply annualised output increases of 8.1% in the E7 but only 0.4% in the G7. Put differently, the E7 account for 3.2 percentage points of current global trend growth of 3.5% per annum. If the recent growth differential were to persist, E7 output would surpass that of the G7 by 2014.

In addition to dominating the longer-term trend, emerging economies have been responsible for 5 percentage points of the 7% recovery in global output since the February 2009 trough. E7 output has already moved ahead of its prior peak and is only marginally below its fast-rising trend. If growth were to continue at its recent pace – plausible given current policy settings and functioning banking systems – emerging economies would overheat in the second half of 2010 and 2011.

The recovery in G7 activity, while less dramatic, has still been significantly stronger than forecast by most economists in early 2009. Output fell by 20% between February 2008 and March 2009 but had recovered by 5% by September. Short-term leading indicators signal a further solid gain in late 2009 – second chart.

G7 central bankers argue that their super-loose monetary policies are warranted by domestic "output gaps" that will exert strong downward pressure on prices. These gaps, however, may be smaller and closing more rapidly than they think. The deviation of G7 industrial output from trend has already narrowed from 14% to 10%.

Policy-makers, moreover, are ignoring inflationary risks from emerging-world buoyancy. Continued above-trend E7 output growth is likely to result in further gains in global commodity prices – third chart. If emerging economies overheat, labour cost and margin elements of prices of exports to the G7 will also increase. If E7 central banks tighten to prevent overheating while G7 policies remain lax, currencies should appreciate, with the same result of higher G7 import prices.

This week's UK Inflation Report contained no discussion of such possibilities. The Bank's view – reflected in Governor King's five explanatory letters over 2007-09 – seems to be that any inflation overshoot due to external factors represents an exogenous "shock" that should not affect policy settings based on "output gapology". Given the above-described global trends, this stance implies that actual inflation is much more likely to exceed than fall below the target – as it has in all but three quarters over the last four years.

Global economic activity has rebounded more strongly than most commentators expected over the last six months. A post last week suggested that this recovery would soon be reflected in a significant improvement in labour market indicators.

The US Conference Board this week reported that its employment trends index – a composite of eight labour market leading indicators – rose for the second consecutive month in October. In the last five US recessions the index bottomed between one and four months before non-farm payroll employment. With its recent low reached in August, this suggests a trough in payrolls by December.

The first chart shows the three-month change in payrolls together with an alternative labour market gauge based on three indicators excluded from the Conference Board measure – the ISM manufacturing employment index, the monthly tally of job-cut announcements by Challenger, Gray and Christmas, and the NFIB small firm hiring plans index. This also suggests an imminent employment trough.

In the UK, promising indicators include the strong Markit / REC job placements index highlighted in last week's post and a further reduction in the net percentage of households expecting higher unemployment in the EU Commission consumer survey – see second chart.

Improving labour market indicators will boost confidence in the sustainability of the economic recovery while calling into question current super-loose monetary policies. In other words, better news for Main Street in early 2010 will represent the first real test of the liquidity-driven rally in markets.

The central projection in the November Inflation Report implies that current monetary policy is the loosest – in terms of calibration to achieve the inflation target over the medium term – in the 12-year history of the Monetary Policy Committee. The forecast casts further doubt on last week's decision to expand asset purchases by another £25 billion to £200 billion.

In the August Report, the MPC projected that inflation would be 2.17% and rising in two years' time based on unchanged interest rates and £175 billion of asset-buying. A key issue in the run-up to last week's meeting was how the Committee could justify further easing against the background of this forecast.

Today's Report provides the answer: the forecast was ignored. The new two-year-ahead projection based on unchanged policy is about 2.3% (estimated from the fan chart). The increase from August is partly due to rolling the forecast forward one quarter but also reflects an upgrade to GDP prospects based on the lower level of the exchange rate and stronger global demand, as well as the further expansion of asset purchases.

At 30 basis points, the positive deviation of the two-year-ahead central forecast from the target is the most since the MPC's inception in 1997 – see chart. The previous largest excess, of 27 basis points, occurred in the May 2004 Report. The MPC raised interest rates in May, June and August 2004.

The MPC's remit is to set policy to achieve the inflation target "at all times". It might be justified to ignore two-year-ahead prospects if inflation were forecast to be persistently below target before or after two years. This, however, is not the case: the central projection is above 2% during the first half of 2010, below 2% between mid 2010 and mid 2011, and above 2% from the second half of 2011.

Another possible defence of current policy settings is that inflation risks are weighted to the downside. The Report, however, states that risks are balanced at the two-year horizon and an inspection of the fan chart does not suggest a significant downward skew to shorter-term forecasts.

The inconsistency between its forecast and last week's further easing poses a risk to the MPC's credibility. Markets, for example, may worry that the Committee is retreating from a pure focus on the inflation target, or placing more weight on avoiding an undershoot than an overshoot, although this would be in conflict with its remit.

The monetary approach to economics argues that "excess"money – the difference between the supply of money and the demand to hold it – is a key influence on spending and financial investment decisions. Assuming that the (unobservable) demand for money is stable, shifts in "excess" money will reflect changes in money supply growth.

Money demand, however, has been unstable in 2008 and 2009. The financial crisis led to an increase in liquidity preference as investors scrambled to sell "risky" assets. More recently, desired cash levels have fallen in response to low interest rates and reviving markets. Strong inflows to US and UK equity and bond mutual funds are one sign of reduced money demand.

The chart shows six-month growth in US broad money M2 together with a six-month running total of flows into or out of US funds, expressed as a percentage of M2. A strong inverse relationship is apparent since the start of 2008. The recent monetary slowdown and pick-up in fund inflows is the mirror-image of late 2008, when a surge in M2 accompanied record outflows.

The implication is that buoyant M2 growth in late 2008 overstated support for the economy and markets from "excess" money because the demand for cash was temporarily elevated by a flight from "risky" assets. Conversely, recent M2 weakness may not imply "deficient" money because liquidity preference has fallen back.

Rather than M2 itself, the sum of money growth and mutual fund flows – the third line in the chart – may provide a better guide to shifts in "excess" money. This indicator has performed well recently: it weakened sharply from mid 2008, warning of a deepening recession, but recovered late last year and in early 2009, foreshadowing the revival in markets and the economy.

Some monetarist economists claim that recent M2 stagnation signals renewed economic weakness in 2010. The indicator incorporating mutual fund flows, however, remains at a healthy level, suggesting monetary underpinnings for an ongoing recovery. This message is supported by more upbeat narrow money trends – see previous post.