Chinese industrial output may be reaccelerating after a temporary slowdown. Adjusting for seasonal variation, the current and future new orders indices in the Market News International (MNI) business survey rose in September – see first chart.

The rebound has been accompanied by a pick-up in input cost and output price pressures. The MNI current and future prices received indices rose sharply this month, suggesting a reversal of the recent slowdown in producer price inflation – second chart.

The weekly food produce price index, meanwhile, continues to climb, signalling a likely further rise in CPI food inflation from an annual 7.5% in August – see previous post and third chart.

Markets have been partying in anticipation of "QE2". Will the Chinese authorities douse the celebrations?

August monetary statistics are encouraging, suggesting a continued economic recovery and arguing against "QE2":

• The Bank's preferred broad money measure, M4ex (i.e. M4 excluding money holdings of "intermediate other financial corporations"), rose by a chunky 0.8% in August and has grown at a 4.5% annualised pace over the last three months.

• Within M4ex, money holdings of private non-financial corporations (PNFCs) gained 0.9%, pushing annual growth up to 5.0%. The corporate liquidity ratio – sterling and foreign currency deposits divided by borrowing – rose to its highest level since the second quarter of 2007. Excluding property companies, the liquidity ratio is close to the top of its range in recent years, supporting hopes of a further pick-up in business investment and hiring – see chart.

• M4ex lending rose by 0.3% following a 0.3% gain in July, resulting in three-month growth turning positive (0.8% annualised). This improvement mainly reflects financial-sector credit but lending to PNFCs also rose marginally in August.

• The QE2 crew will point to still-low annual growth in M4ex – 1.6% last month after 1.2% in July. They neglect that broad money velocity is rising fast – by 4.3% in the year to the second quarter, allowing nominal GDP to expand by 5.7%. When real interest rates were last negative for a sustained period in the 1970s, velocity rose by a cumulative 38.6% over six years, or 5.6% annualised. A similar trend is plausible now, suggesting that broad money expansion of 1-2% per annum is more than sufficient to finance sustainable economic growth of about 2.5% with 2% inflation.

• Monetary expansion continues to be supported by an influx of foreign funds – overseas investors bought £9.5 billion of gilts and Treasury bills in August, bringing the year-to-date total to £62.1 billion, while "monetary financial institutions' externals" contributed £15.1 billion to the increase in M4. 

The big news in today's national accounts release is a fall in the household saving ratio to just 3.2% in the second quarter from 5.5% in the first (revised down significantly from 6.9%). This will increase fears that the recovery is at risk from renewed weakness in consumer spending as households attempt to rebuild their finances.

Such worries are overblown, for two reasons. First, the fall in the ratio between the first and second quarters partly reflected a large drop in dividend income, which is likely to prove temporary given strong corporate free cash flow. (BP suspended its dividend last quarter but is expected to resume payment in early 2011.)

Secondly, the fall in household saving was more than offset by a decline in government current borrowing and higher corporate retained earnings. Accordingly, the national saving ratio (i.e. the proportion of gross national income not consumed) rose in the second quarter, though remains low – see chart.

Encouragingly, companies are using higher saving to expand capital spending, circumventing the banks – business investment was revised up to show a 0.7% increase last quarter after a 7.9% first-quarter gain. The fall in government borrowing, meanwhile, may temper worries about future tax rises, encouraging households to maintain a lower saving ratio.

This week's Federal Reserve policy statement raised market expectations of "QE2" asset purchases but, perversely, the Fed has allowed the monetary base – currency in circulation plus banks' reserve balances – to contract recently. The base fell by 2.7% in the week to Wednesday to stand at its lowest level since January and 10.1% below the February peak – see chart.

The decline in the latest week reflected a rise in the Treasury's general account balance at the Fed, which resulted in an equivalent outflow from banks' reserves. The general account balance fluctuates as receipts from taxes and debt sales vary in relation to Treasury outlays but the Fed, in theory, can offset the impact on reserves, for example by offering banks repo loans or increasing securities purchases.

If the Fed wished to boost the monetary base ahead of any QE2 decision, it could ask the Treasury to reduce the $200 billion balance in its "supplementary financing account". An increase in this balance was used to drain cash from banks' reserves this spring, when the Fed was mulling an "exit strategy" – discussed in a post at the time.

The fall in the base may prove temporary but the Fed's failure to offer resistance suggests that the internal debate has yet to be resolved in favour of further easing.

As originally discussed in a post last year and illustrated by the chart, fluctuations in the monetary base have tended to lead stock market movements since the Fed embarked on "QE1" in late 2008.

"QE2" is the wrong response to recent economic softening and, if implemented, is likely to prove counterproductive.

Some QE2 proponents claim that G7 economies are suffering from a shortage of liquidity, evidenced by slow expansion in the broad money supply. (The UK's preferred broad money measure rose by only 1.2% in the year to July, though growth has been faster over the last six months.) An assessment of monetary adequacy, however, must take account of demand as well as supply. Money demand has been depressed by negative real interest rates, which have encouraged a large-scale portfolio shift out of deposits into other assets offering a higher yield and / or inflation protection. Record mutual fund inflows are one reflection of this adjustment.

Put differently, slow money supply expansion is being offset by a rise in the velocity of circulation. Broad money velocity rose by 4.4% in the UK in the year to the second quarter, allowing nominal GDP to expand by 5.9%. When real interest rates were last negative for a sustained period in the 1970s, velocity rose by a cumulative 38.6% over six years, or 5.6% annualised. A similar rate of increase is plausible now, suggesting that broad money expansion of 1-2% per annum is more than sufficient to finance trend economic growth of about 2.5% with 2% inflation.

Rather than inadequate monetary growth, the Federal Reserve this week cited dangerously-low inflation as a reason for considering QE2. The rise of just 0.9% in the consumer price index excluding food and energy over the last year, however, is heavily influenced by a 0.3% fall in "owners' equivalent rent" – a theoretical sum paid by home-owners to themselves. An alternative CPI measure based on the EU's harmonised methodology, which omits imputed rent, rose by 2.1% in the year to July, according to a comparison table produced by the Bureau of Labor Statistics.

There has been no sudden deterioration in inflation news to warrant the Fed's heightened concern. The CPI excluding food and energy increased by an annualised 1.3% in the three months to August, above the 0.9% annual gain. The September University of Michigan consumer survey reported a mean expectation for inflation over the next five years of 3.2%, equal to the average of the last two years.

Some economists support more QE not because they think it is strictly necessary but as an "insurance policy". This wrongly assumes that it would be costless. Additional liquidity, however, might flow into already-overheated financial markets, risking the formation of new bubbles and subsequent disruptive busts.

QE2, indeed, is probably already harming economic prospects by encouraging further speculative buying of food commodities. Recent commodity price gains suggest that G7 CPI food inflation will rise from an annual 0.9% in July to 4-5% – see chart. This would add 0.3-0.4 percentage points to headline CPI inflation, with an equivalent negative impact on consumer purchasing power. As discussed yesterday, the effects will be more serious in emerging economies.

Recoveries proceed in fits and starts and policy-makers should be cautious about attempts at "fine-tuning", which may simply increase volatility. To the extent that policy is constraining economic expansion, proposed tax increases and their impact on confidence are of greater concern than insufficiently loose monetary conditions. In the UK, this argues for postponing or cancelling the planned VAT hike, which will pile more pressure on struggling consumers and may no longer be required given recent deficit improvement – see previous post.

Rising food prices may crimp UK consumer spending later this year but food inflation is a much bigger issue in emerging economies – the average weight of food in the CPI baskets of 120 non-OECD countries was 37% in 2006, according to a 2008 IMF study, versus 10% in the UK currently. (Food is much more important for consumers in these economies than fuel, with a 7% average weight in 2006.)

Chinese CPI food inflation rose to an annual 7.5% in August and may reach 9% by October, judging from data on edible agricultural product prices – see chart. (Product prices suggest a further increase of 1% or more in the CPI food index, which was little changed between August and October last year.) With food accounting for one-third of the CPI basket, this could push headline CPI inflation up from 3.5% currently to about 4%.