ECB President Trichet yesterday warned of a possible July rate rise, in line with the hawkish message from my ECB-ometer – see here. Any increase is unlikely to mark the start of a new trend, however. One reason is that the ECB’s policy stance is already reasonably restrictive – the current repo rate still exceeds headline CPI inflation and is comfortably above the core rate (i.e. excluding food and energy).

The same cannot be said of the US and many emerging markets. The chart below shows weighted averages of short-term interest rates and CPI inflation in our “E7” grouping of major emerging economies (Brazil, Russia, India, China, Korea, Taiwan, Mexico). Central banks in these countries are in tightening mode but in most cases look well “behind the curve” (exception: Brazil). Officials are reluctant to move aggressively partly for fear of excessive currency strength given the super-low level of US rates.

The Fed’s maxi-ease is creating global not just domestic inflationary headaches.

I have been critical of the Fed's rate-slashing campaign between September and April. Rather than supporting the economy, the cuts have undermined the dollar and boosted commodity prices, thereby increasing inflationary risks. Fed Chairman Bernanke’s musings this week on the desirability of a stronger US currency appear to represent belated acknowledgement of such criticisms.

Talk is cheap but is the Fed prepared to adopt policies to support the dollar? As the first chart below shows, the US trade position is improving relative to Euroland, laying one of the foundations for a recovery in the dollar versus the euro. However, it may be difficult for the currency to achieve a meaningful gain given the large gap between real policy interest rates in the US – now negative – and Euroland.

One indicator that has provided advance warning of Fed policy shifts historically is the ISM manufacturing delivery times index. Lengthening delivery times signal rising pressure on supply capacity, which may warrant Fed tightening. The index has recently moved into the region associated with rate increases – see second chart. With this indicator and the dollar both suggesting tighter policy, will the Fed move quickly to withdraw stimulus if the economy recovers in the second half, as seems plausible?

My tentative expectation is that global growth indicators will stabilise this summer and improve during the second half, mainly reflecting a revival in the US – see yesterday’s post and here. The latest US purchasing managers’ surveys seem consistent with this scenario. As the first chart shows, the new business indicator rose to a seven-month high in May and is at a level historically consistent with GDP growth of about 2% annualised.

The improvement in the US surveys contrasts with a further deterioration in Europe – particularly the UK. A rotation of growth momentum back to the US would be consistent with my regional monetary conditions indicators, shown in the second chart. It would also fit with the outperformance of US equities relative to Europe year-to-date.

One risk to my global scenario is that European weakness will outweigh any revival in US momentum. Based on the latest surveys, the US effect seems likely to dominate. Also, business confidence is positively correlated across countries – this month’s US improvement could be precursor of a stabilisation in European indicators.

Previous posts have compared annual industrial output growth in the Group of Seven (G7) major economies with soft landing and hard landing scenarios, based on average experience in prior downswings over the last 40 years. I have been expecting an outcome closer to the soft landing path in 2008, with major economic weakness possibly delayed until 2009 / 2010 (see here).

Based on partial data, annual growth appears to have fallen below 1% in April but is still reasonably close to the soft landing scenario – see first chart. As suggested in my last update, the annual change could fall close to zero by mid year, reflecting further credit tightening and commodity cost increases in early 2008.

If the historical comparison is still relevant, growth should show some recovery in the second half and into early 2009. Prospects of such a pick-up have been damaged by the recent oil price surge but my survey-based leading indicator registered a small increase in May, consistent with a possible mid-year trough – see second chart. More data are clearly needed to confirm this scenario.

Historically, recoveries following soft landings have been of short duration, partly because inflationary pressures quickly re-emerge, necessitating policy tightening. As the first chart shows, the soft landing path turns down sharply from early 2009. Any improvement in global economic news during the second half should be regarded as temporary relief.

Like the ECB-ometer (last post), my MPC-ometer has shifted in a hawkish direction over the last month. The May projection was for a 6-3 vote for unchanged rates, with three doves; the outturn was 8-1, with only David Blanchflower voting for a cut. This month the model suggests another 8-1 decision.

Activity indicators have weakened further and are at a level historically consistent with a half-point cut. However, the impact on the forecast has been outweighed by ongoing deterioration in the model’s inflation components. Consumer inflation expectations, manufacturers’ price-raising plans, average earnings growth and future inflation discounted by gilt yields have all risen over the month.

The MPC will not have early access to the May CPI numbers. Given the possibility that these will show a rise in annual inflation to the 3.1% letter-writing level, even those MPC members with an easing bias are likely to be reluctant to join David Blanchflower in voting for a cut this month.

For comparison, the Sunday Times Shadow MPC also voted 8-1 to keep rates on hold this month, following a narrow 5-4 decision last month. The MPC-ometer has a slightly better record over the 20 months since its inception: its average error has been 1.6 quarter-point votes per month versus 2.7 for the Shadow Committee.