There was little macroeconomic "news" in the Spending Review.

The Chancellor confirmed the current expenditure totals set out in the June Budget. By cutting a further £7.0 billion from the welfare budget and finding other savings of £3.5 billion, however, he was able to moderate the squeeze on departmental current spending, which will be £10.3 billion higher than previously announced by 2014-15.

There is also a small rise in capital spending relative to previous plans, of £2.3 billion by 2014-15. The investment outlook, however, is still grim, with a real-terms fall of 39% between 2009-10 and 2014-15.

"Total managed expenditure" (TME) – current plus capital spending – is projected to peak this year and fall by 3.3% in real terms by 2014-15. Contrary to popular assertion, such a decline is not unprecedented – following the IMF rescue in 1976, real TME was cut by 3.9% in a single year in 1977-78.

As a proportion of GDP, TME will fall from a peak of 47.5% in 2009-10 to 41.0% by 2014-15 – a cut of 6.5 percentage points over five years. This also has historical precedent: the TME share declined by 6.5 percentage points in five years from a peak in 1982-83 and by 5.5 percentage points in five years from 1992-93 – see chart.

A projected 1.2% real-terms reduction in TME in 2011-12, equivalent to about £8 billion, is unlikely to derail the economic recovery. A much greater threat is posed by previously-announced tax measures designed to raise nearly £20 billion next year – see previous post.

Public sector net borrowing excluding the temporary impact of financial interventions (PSNB ex) rose to £16.2 billion in September from £15.5 billion a year earlier. Incorporating a £0.7 billion downward revision to earlier months in 2010-11, however, borrowing still looks on course to undershoot the Office for Budget Responsibility's (OBR) full-year forecast of £149 billion.

The chart shows a crude attempt to adjust the monthly numbers for seasonal variation: adjusted borrowing averaged £11.75 billion in the first six months of the fiscal year, or £141 billion annualised – see chart. The OBR forecast, therefore, implies renewed deterioration over the remainder of 2010-11. This is unlikely because the benefits of economic recovery should grow as the year progresses while much of the £8.1 billion of spending cuts and tax rises announced since the election has yet to take effect.

Central government current expenditure rose by 6.8% in the six months to September from a year earlier, above the OBR's projection of full-year growth of 5.6%. This was more than offset, however, by a 9.2% increase in current receipts, versus a 6.5% full-year forecast.

The figures also indicate that capital spending has yet to be reined back. Public sector net investment was little changed in the six months to September from a year earlier, implying a drastic cut over the remainder of 2010-11 to achieve the OBR projection of a 21% full-year reduction.

The expenditure cuts to be spelt out in tomorrow's Spending Review will be criticised for endangering the economic recovery. In reality, coming tax increases pose a much greater threat to growth next year.

The Treasury claims that 77% of planned fiscal consolidation between 2009-10 and 2015-16 will occur via expenditure restraint rather than higher taxes. The proportion, however, is lower in the early years – only 57% by 2011-12. This is because spending cuts are being phased in while tax rises are front-loaded.

The Treasury's estimate of the split, moreover, may be questioned. Expressed at constant (i.e. 2011-12) prices, total managed expenditure is projected to fall by just £2 billion between 2009-10 and 2011-12 versus a £45 billion increase in current receipts  – see chart. This suggests that taxes will bear 96% of the burden of adjustment by 2011-12 rather than the 43% claimed by the Treasury.

Tax increases announced by either the coalition or the previous Labour government (since the 2008 Pre-Budget Report), with estimates of the 2011-12 yield in brackets, include:

• Rise in national insurance rates offset by higher thresholds / new business relief from April 2011 (£2.6 billion)

• Restrictions on pensions tax relief from April 2011 (£0.6 billion based on previous government's proposals, rising to £4.0 billion in 2012-13)

• Rise in main VAT rate to 20% from January 2011 (£12.1 billion)

• Rise in insurance premium tax from January 2011 (£0.5 billion)

• Bank levy from January 2011 (£1.2 billion)

• Rise in higher-rate capital gains tax to 28% from June 2010 (£0.7 billion)

• Additional 50% higher income tax rate from April 2010 (£3.1 billion, up from £1.3 billion in 2010-11)

• Withdrawal of personal allowance from £100,000 from April 2010 (£1.5 billion, up from £0.9 billion in 2010-11)

These increases dwarf the planned £1,000 rise in the personal allowance (costing £3.5 billion in 2011-12) and a phased reduction in corporation tax (£0.4 billion, rising to £1.2 billion in 2012-13).

US monetary trends continue to strengthen on a variety of measures* – see chart. The broader M2 aggregate has risen at a 5.7% annualised pace over the last six months, the fastest growth rate since June 2009. Money supply weakness late last year and in early 2010 foreshadowed the current "soft patch" in activity so the recent pick-up suggests improving economic prospects for early 2011.

The Federal Reserve, of course, ignores monetary trends – there was no mention of money in Chairman Bernanke's latest speech setting out the case for "QE2". Its actions, therefore, tend to be destabilising – it ceased asset purchases in April 2010 when the money supply was worryingly weak and now plans to resume buying even as monetary expansion picks up. Since the economy is not suffering from a deficiency of money, a further QE2 injection may simply lead to an artificial rise in asset prices or higher goods and services inflation.

* Definitions:
M1 = currency and checkable deposits
M2 = M1 plus savings deposits, small time deposits and retail money funds
MZM = money of zero maturity = M1 plus savings deposits and all money funds
M2+ = M2 plus large time deposits at banks and institutional money funds (author's definition and calculation)
Note: M3 = M2+ plus repurchase agreements and Eurodollar deposits (no longer published)

Few economists are talking about a possible near-term inflation rise – see Tuesday's post – but it is on the Bank of England's radar, judging from a speech this week by MPC hawk Andrew Sentance:

We have seen two major spikes in CPI inflation within the last two years. And it is possible that another one is in prospect when higher VAT comes into effect early next year, particularly if this is accompanied by a continuation of the recent surge in energy and commodity prices. These repeated episodes risk eroding confidence that UK policy-makers remain committed to low and stable inflation, with a knock-on effect on inflation expectations in financial markets, among the business community and the public which could be self-fulfilling.

Equity market valuation is often assessed using Professor Robert Shiller's "cyclically-adjusted price-earnings ratio" (CAPE), which divides the real (i.e. inflation-adjusted) index level by a 10-year one-sided moving average of real earnings per share. The smoothing is an attempt to estimate trend earnings, with 10 years consistent with the typical 7-11 year length of the dominant economic cycle (the Juglar business investment cycle).

For the S&P 500, Shiller's CAPE stood at 21.0 in early October versus a median since 1881 of 15.7, a 34% premium, suggesting that equities are significantly overvalued relative to history – see first chart.

Because the moving average is one-sided, however, it can under- or overstate trend earnings when the growth rate is changing. S&P 500 trend earnings expansion may have accelerated in recent years, partly reflecting a stronger contribution from foreign profits related to US companies' exposure to emerging economies.

A further problem at present is that, unusually, the 10-year moving average incorporates two major earnings recessions, reflecting the proximity of the 2001 and 2008 economic downturns. These two factors suggest that Shiller's CAPE is overstating equity market valuation.

The first issue can be addressed by using a two-sided moving average, so that the trend measure incorporates future as well as past data. The average, of course, cannot be calculated for recent years (the last five years in the case of a 10-year window). Trend, however, can be estimated using consensus earnings forecasts and extrapolation – the estimates will be subject to revision but the procedure may produce superior results to one-sided smoothing.

This two-sided approach also solves the current problem of the moving average incorporating two earnings recessions, since the 2001 downturn is no longer within the time window of the calculation.

The second chart shows S&P real earnings per share, expressed at 2010 prices, together with an estimate of trend calculated on this basis. Earnings are back at trend following an unprecedented collapse in 2008-09.

The third chart shows a price-earnings ratio calculated using the trend earnings measure. The current level of 16.3 compares with a median since 1881 of 14.5 – still 12% higher but a much smaller deviation than for Shiller's CAPE.

Comparing current valuations with a median extending back to the late 1800s is questionable – the equity risk premium may have fallen, reflecting such factors as greater diversification possibilities, improved liquidity and lower trading costs. As the second chart shows, a trend line through the data has a mild upward slope. If this line, rather than the median, is used to gauge sustainability, equities are 8% undervalued, based on a current price-trend earnings ratio of 17.7.