A monthly GDP estimate derived from data on services and industrial output fell by 0.2% between February and March, the smallest decline since October – see chart. The slower pace of contraction is consistent with better purchasing managers' survey results in March; PMI readings continued to improve in April.

The monthly estimate was 0.3% below its first-quarter average level in March, suggesting that second-quarter GDP figures – released in late July – will show a further decline. Based on current PMI readings, however, this could be smaller than the 0.6% fall implied by the Bank of England's latest Inflation Report forecast. The Bank is projecting a further contraction of 0.3-0.4% in the third quarter.

Today's numbers confirm a 1.9% GDP fall between the fourth and first quarters, with the expenditure breakdown showing broad-based weakness. A silver lining, however, is that destocking rose further to reach 2.0% of the level of GDP – the highest on record in quarterly data going back to 1955. A slowdown in stock liquidation will provide important support to the economy later in 2009.

Provisional April monetary statistics released today do not include new information on the MPC's favoured broad money aggregate – M4 excluding deposits of "intermediate other financial corporations". On the basis of the data provided, however, this measure is likely to have grown moderately last month.

Headline M4 rose by just 0.1% in April but the release notes a negative impact from a fall in repos with "other financial corporations". To the extent that this decline reflected transactions with financial intermediaries, it will not affect the MPC's adjusted M4 measure. Without the repo change, M4 would have grown by 0.5% last month, or about 6% annualised.

The Bank of England's gilt purchases were reflected in a large public sector contribution to M4 growth in April – "net sterling lending to the public sector" amounted to £30 billion or 1.5% of M4. This boost, however, was partly offset by weakness in private sector sterling credit and a large fall in "net other assets".

Overall, the figures – while incomplete – are slightly disappointing and support the MPC's decision to expand the QE programme.

Today's Financial Times draws attention to the huge deterioration in the UK's relative inflation performance caused by last year's plunge in the exchange rate, a topic discussed in an earlier post. Its observations, however, should be qualified in two respects.

First, the FT uses the CPI excluding indirect taxes as a gauge of "true" inflation, i.e. adjusting for the impact of December's VAT cut. This rose an annual 3.8% in April versus a 2.3% increase in the headline CPI. A better measure, however, is the CPI at constant tax rates (CPI-CT), which climbed by a smaller 3.4%.

Moreover, both of these alternative indices are based on the assumption that the VAT reduction was passed on in full – highly unlikely. Using a more realistic estimate of 50% pass-through, "true" inflation in April was 2.8-2.9% (i.e. halfway between the headline 2.3% and 3.4% CPI-CT increases).

Secondly, as discussed in a post last week, recent sterling strength – if sustained – promises a reduction in imported inflationary pressures later in 2009. The MPC's central-case forecast that the annual CPI increase will slow to 0.4% by the fourth quarter looks much too optimistic but the gap between UK and US / Eurozone inflation is peaking and should narrow significantly.

For the gilt market, supply is likely to represent a greater threat than relatively high UK inflation. The stock of gilts in market hands should shrink by about £50 billion over March-July, with Bank of England purchases of £120 billion offsetting net issuance of £70 billion. If the MPC were to suspend QE purchases from August, however, the market would need to absorb supply of £130-135 billion in the final eight months of 2009-10. (The DMO plans to issue a net £203 billion this fiscal year, based on the Treasury's forecast of public net borrowing of £175 billion.)

In other news today, minutes of this month's MPC meeting show that that some members favoured expanding QE by £75 billion rather than £50 billion, while the Committee discussed writing a letter to the Chancellor requesting an increase in the £150 billion limit "should economic conditions require it". This is likely to fuel expectations that gilt-buying will be extended beyond early August but such a decision will depend importantly on forthcoming monetary data (provisional April broad money numbers are released tomorrow).

Meanwhile, Inflation Report forecast tables show that the MPC expects annual average GDP changes of -4.0% in 2009, 1.1% in 2010 and 2.7% in 2011 in its central case based on market interest rate assumptions. However, its mean projections – taking into account a negative risk skew – are much weaker, at -4.2%, -0.2% and 1.6% respectively. This looks excessively gloomy – see last post.

The recession probability indicator discussed in earlier posts signals that the UK economy will return to growth by early 2010. The indicator is less gloomy than the latest Bank of England Inflation Report and suggests that the Treasury's forecast of a 1.25% rise in GDP in 2010 is achievable. However, a full recovery – in the sense of trend economic growth or higher – will require faster monetary expansion.

The indicator estimates the probability of the economy being in a recession three quarters ahead based on a range of monetary and financial inputs, including inflation-adjusted broad and narrow money supply growth, companies' liquidity ratio, three-month LIBOR, the yield spread between corporate and government bonds, share prices and the effective exchange rate. A recession is defined as an annual fall in GDP – a stricter interpretation than often employed.

The recession probability estimate began to climb in the second half of 2007 and reached a peak of 91% at the end of 2008 in the wake of Lehman's collapse – see chart. It fell back to 71% in the first quarter of 2009, however, and a further decline to 33% is indicated for the second quarter, using the latest values for the inputs.

Allowing for the nine-month lead, therefore, the indicator suggests a two-thirds chance that annual GDP growth will be positive in the first quarter of 2010. In other words, any further near-term decline in output is likely to be recouped in late 2009 and / or early 2010. By contrast, the latest Inflation Report fan chart appears to imply only a 40% chance of positive annual growth in the first quarter of 2010 (precise figures will be available tomorrow).

The indicator's output can also be expressed as a mean forecast for annual GDP growth three quarters ahead. Based on the latest input values, the forecast for the first quarter of 2010 is 0.7%. The Treasury's projection of 1.25% GDP growth for 2010 as a whole therefore appears reasonable, barring an economic relapse later next year.

The fall in the recession probability estimate has been driven by declines in short-term interest rates and the effective exchange rate and – more recently – firmer real money growth, a rally in share prices and narrower credit spreads. With little scope for short rates to move lower, however, and sterling finding a floor recently, further improvement is likely to depend on stronger monetary trends.

It would be surprising if the expanded £125 billion QE programme – equivalent to 8% of the adjusted M4 money supply – failed to produce a monetary pick-up. Provisional April broad money figures published on Thursday will provide more information on the impact of recent official gilt purchases.