The Bank of England's gilt purchases have had a smaller-than-expected impact on the broad money supply. This is partly because liquidity has flowed overseas – see a previous post for more details. In addition, the Bank's purchases have been offset by a fall in demand for gilts from commercial banks. It is the combined buying of the Bank and commercial banks that determines the impact on broad money.

The table shows transactions in gilts by various groups in the six month periods before and after official gilt-buying started in March. Commercial banks increased their holdings by £37 billion in late 2008 and early 2009 but sold £10 billion of gilts between March and August (the latest available month). The £47 billion reduction in their demand between the two periods offset more than one-third of the £133 billion increase in Bank of England buying.

The change in banks' behaviour reflects the huge build-up of cash in their accounts at the Bank of England resulting from the Bank's gilt purchases. Banks needed to boost their liquidity reserves but, since March, have been able to achieve this goal without buying more gilts. Their combined holdings of gilts and central bank cash rose by £83 billion between March and August, up from £43 billion over September-February.

When the Bank of England expanded its buying plans in August, however, it also severed the link between gilt purchases and the amount of cash in banks' reserve accounts, by simultaneously suspending its lending in weekly open market operations. The contractionary effect of this change has outweighed the injection from continuing gilt-buying so banks' cash levels have fallen recently – see chart.

New Financial Services Authority rules require banks to raise their liquid asset holdings significantly further, although the regulations will be applied over several years. With the Bank of England no longer increasing cash reserves, this implies purchases of gilts and Treasury bills. Stronger demand from banks could partly offset the effects on money supply trends and gilt yields of a suspension or slowdown in official gilt-buying.

The charts below update forecasts for consumer and retail price inflation presented in a previous post. Recent CPI outturns have been in line with the earlier projection but RPI figures have been higher than expected, partly reflecting house price gains. (House prices enter the RPI via a component measuring housing depreciation costs.)

The new forecasts are based on the same underlying approach as described in the earlier post but assumptions about food, energy and house prices have been updated. In addition, the projection for CPI inflation excluding unprocessed food and energy over the next year has been raised slightly to take account of recent exchange rate weakness. (At yesterday's close of 77.5, sterling's effective rate was 7% below the level assumed in the August Inflation Report.)

From its September level of 1.1%, annual CPI inflation is projected to rise sharply to nearly 3% in January before drifting lower over the remainder of 2010. The increase reflects unfavourable energy price base effects and the reinstatement of a 17.5% standard rate of VAT from January. The VAT change is assumed to add 0.5% to the CPI – equal to an estimate by the Office for National Statistics of the initial impact of last December's reduction to 15%.

The projections are arguably conservative in two respects. First, energy utility tariffs are assumed to fall by 5% around the end of 2009, reflecting government pressure on suppliers to pass on earlier reductions in wholesale gas prices. Gas costs, however, have rebounded recently while companies may continue to resist cuts on the basis that profits need to rise to finance huge future investment requirements. Without a reduction, the January inflation rate might hit the 3.1% level necessitating an explanatory letter from Bank of England Governor King.

Secondly, annual inflation excluding unprocessed food and energy prices, and adjusted for the VAT effect, is projected to fall to 1.5% by the end of 2010 in lagged response to slower monetary growth, explaining the drift lower in the headline rate later next year. This compares with a current estimated rate of 2.5%. Core inflation has recently proved stickier than most forecasters expected and this could continue, particularly if the exchange rate remains weak.

The projections are significantly higher than those published by the Bank of England in the August Inflation Report – this shows average inflation of 2.1% in the first quarter of 2010, falling to 1.5% by the fourth quarter assuming an unchanged level of Bank rate. With recent figures above its expectations, and the pound much weaker, the Bank is likely to revise up its near-term forecasts once again in the November Inflation Report.

RPI inflation will rise even more sharply than the CPI measure, reflecting unfavourable mortgage rate and house price base effects in addition to the factors cited above. From -1.4% in September, the headline rate is forecast to rise to more than 3% next spring based on an unchanged Bank rate, with higher levels obviously implied by any increase in official rates. (The alternative scenario in the chart assumes that the average mortgage rate rises by half the amount of the change in Bank rate, consistent with the roughly 60% share of variable-rate loans in total mortgage debt outstanding.) The projections are based on house prices stabilising at current levels – probably again conservative, particularly if Bank rate remains at 0.5%.

The fall in annual CPI inflation to 1.1% in September reflected energy base effects and lower food prices and was in line with a forecast presented in an earlier post. Inflation is likely to climb sharply over the next few months, with a risk that it breaches 3% in January, necessitating an explanatory letter from Bank of England Governor King to the Chancellor

At the August Inflation Report press conference, Mr King stated that it was "more likely than not" that he would have to write a letter explaining an undershoot of 1% later in 2009. Because of the favourable energy base effect, any such shortfall was expected to occur in September. With the odds in favour of a rebound in October and beyond, an undershoot letter is now unlikely.

Despite the fall in September, inflation averaged 1.5% in the third quarter, comfortably above the Bank's forecast of 1.3% made just two months ago. Coupled with the recent plunge in the exchange rate, this should lead the Bank to revise up its near-term projections once again in the November Inflation Report. It currently forecasts average inflation of 1.3% and 2.1% in the fourth and first quarters.

While the 1.1% September outturn is well below the 2% target, the shortfall is entirely explained by lower energy costs and last December's VAT reduction. Core CPI inflation – excluding energy, food, alcohol and tobacoo – was 1.7% last month and would probably stand at 2.3-2.4% in the absence of the VAT change (based on official estimates of its impact).

The Bank, like the consensus, thought CPI inflation would fall by much more than it has this year – the May Inflation Report projected a drop to just 0.4% in the fourth quarter. Forecasting models gave too little weight to the impact of sterling's decline while placing overreliance on highly-uncertain estimates of the "output gap" and its influence on pricing decisions. (These issues were discussed in a post in March.)

With CPI inflation overshooting its projections, and the core VAT-adjusted rate above the 2% target, today's numbers do not warrant a further expansion of the Bank's quantitative easing programme next month. As argued in a post last week, there is evidence that the Bank's gilt-buying is creating excess liquidity in the economy and a further monetary injection could lead to an accelerating decline in the currency.

Last week's gains in equity and commodity prices, and the further fall in the dollar, followed a moderately disappointing US employment report the previous Friday. This reinforced expectations that the Federal Reserve will maintain rates near zero and continue to supply ample liquidity for the foreseeable future. Comments last week by Fed Chairman Bernanke on exit strategy and National Economic Council Director Summers favouring a strong dollar failed to dent this consensus.

The current sensitivity of markets to the Fed's liquidity provision was discussed in an article by Andy Kessler published in the Wall Street Journal in July. The article included a chart showing a correlation this year between the Dow Jones industrial average and a weekly monetary base measure calculated by the St Louis Fed. (The monetary base comprises currency in circulation and banks' reserve balances with the Fed.)

An updated version of the chart is shown below, with the start date moved back to September last year – the monetary base began to surge following Lehman's collapse. The apparent relationship has continued since the summer, with the Dow's new rally highs last week accompanied by the weekly base moving above its May peak.

The theoretical basis of the relationship is questionable and it is unlikely to survive over the medium term. Markets, however, are unusually sensitive to news about the Fed's policy stance currently and many investors seem to be interpreting the weekly monetary base as a real-time indicator of policy-makers' intentions.

The Fed's ongoing securities purchases will tend to expand the base further although the impact could be offset by other factors, such as reduced emergency lending to the banking system or a moderation in the public's demand to hold currency. The weekly numbers may continue to hold exaggerated significance for both bulls and bears.

The strong consensus in favour of the Fed staying "loose for long" rests on a forecast that employment will continue to decline into year-end, resuming growth only in early 2010. The key risk for liquidity-driven markets is an earlier-than-expected return of jobs expansion. Perversely, any "good" labour market news will warrant increased investor caution.