While no doubt distorted, the shock 3.5% surge in retail sales in May shows that households are not yet adjusting to the stagnation in their living standards implied by higher food and energy prices, as Mervyn King has argued they must if inflation is to return to the 2% target. Even more worryingly, some consumers may be bringing forward spending in anticipation of future price rises, a possibility that will heighten MPC fears that inflation expectations have become dislodged from the target.

While the sales figures will capture the headlines, however, a further slowdown in money supply growth suggests longer-term inflationary risks are diminishing. M4 rose by 10.0% in the year to May, down from 11.0% in April and the lowest annual increase since February 2005. Corporate liquidity trends have been particularly weak recently (see here), implying worsening prospects for business spending – an offset to concerns about (temporary) consumer resilience.

The risk of a rate rise has increased but monetary trends suggest current policy settings are already sufficiently restrictive.

In yesterday’s explanatory letter to the Chancellor, Bank of England Governor Mervyn King claimed that “pay growth has remained moderate”. The official average earnings index (AEI) excluding bonuses rose by 3.8% in the year to April – equal to the average annual growth rate over the last five years.

The alternative average weekly earnings (AWE) series, however, is giving a less benign message. This measure is based on the same underlying data as the official index but uses a different aggregation methodology. Figures released today show earnings excluding bonuses growing at a 4.7% annual rate in April – well above the official measure and the highest rate of increase since August last year.

With the MPC on alert for “second round” inflation effects, the divergence between the two measures creates a policy headache. It is unclear which is the better guide – National Statistics launched a review of the AWE methodology in February, which was due to report in April but has been delayed. The MPC may be right to emphasise the AEI but confusion over current pay trends increases the risk of a policy mistake.

The letter attributes the overshoot entirely to world commodity price pressures. It is disappointing that there is no acknowledgement of the role of excessive monetary growth in accommodating the impact of these pressures on domestic prices.

Mr. King implies policy settings have been appropriate because money spending grew by 5½% in the year to Q1 2008, in line with its average rate of increase since 1997. However, spending expanded by 6¼% pa in the two years to Q3 2007, when domestic monetary conditions were arguably too loose. This was about one percentage point above a level consistent with achievement of the inflation target. (The deflator for money spending has risen about ½% pa faster than the CPI over the long term. Allowing for trend growth of 2¾%, this suggests money spending should expand by 5¼% pa to hit the 2% CPI inflation target over the medium term.)

Bizarrely, while ignoring the past role of high monetary growth, Mr. King cites a recent slowdown in the broad money supply as a reason for expecting inflation to return to target.

The 12% fall in sterling since last summer is given as a reason for expecting inflation to rise significantly further in the near term. However, MPC members, including Mr. King, have previously expressed satisfaction with a lower exchange rate, arguing that it was necessary to “rebalance” the economy.

Unsurprisingly, the letter implies current official rates are appropriate, balancing upside and downside risks. Any hint of a bias would have raised the question of why rates were not moved at the meeting less than two weeks ago.

An especially shocking feature of today’s figures was the further surge in RPIX inflation (i.e. excluding mortgage interest rates) from 4.0% to 4.4% – 1.9 percentage points above the old 2.5% target for this measure.

Northern Rock appears to be repaying its Bank of England loan faster than projected in its restructuring plan. While good news for Ron Sandler & co., Rock’s rapid shrinkage is exacerbating the current mortgage market squeeze, with negative macroeconomic implications.

The restructuring plan projects a 25% repayment of the BoE / government loan in 2008, implying a reduction from £26.9 billion on 31 December 2007 to about £20 billion. According to a trading update on 12 May, the loan had declined to £24.1 billion by 31 March. More recent developments can be estimated from the weekly BoE return. “Other assets” fell by £7.9 billion between 2 April and last week. As well as the Rock loan, this category includes foreign currency lending, which may have declined by £4 billion over this period, judging from information in the latest BoE Quarterly Bulletin (see p.137). A reasonable assumption is that Rock has repaid a further £3-4 billion since the end of March, implying the outstanding loan may already be close to the £20 billion full-year target.

The repayment is likely to have been funded mainly from mortgage redemptions. The restructuring plan projects a fall in Northern Rock’s share of the stock of mortgages from 7.5% at the end of last year to 3.7% by December 2009, implying a nominal reduction of about £20 billion a year in 2008 and 2009. Economy-wide net mortgage lending totalled in £108 billion last year, of which Rock contributed £13 billion. Its U-turn will therefore cut the supply of mortgage loans by over £30 billion in 2008 compared with last year – significantly worsening the impact of the wider credit “crisis”.

The government may be constrained by EU state aid regulations but a less rapid reduction in Northern Rock’s mortgage book would help to reduce the risk of a severe economic downturn.