US labour demand is recovering but firms remain cautious, preferring to use existing workers more intensively and employ temporary staff rather than expand permanent jobs.

January figures show that non-farm payrolls were essentially flat over the last three months: the establishment survey measure fell by 0.1% while an alternative measure from the household survey rose by 0.1% – see first chart. With the average workweek lengthening from 33.0 to 33.3 hours, however, aggregate hours worked in the private sector grew by 1.0% – the largest increase since late 2006. Firms, meanwhile, added a record 205,000 "temporary help" jobs over the last three months.

Global industrial output should continue to recover solidly in early 2010, judging from OECD leading indices for December, also released today – second chart.

As expected, the Monetary Policy Committee voted to suspend reserves-financed asset purchases at £200 billion while maintaining Bank rate at 0.5%.

The key passage in the accompanying statement is:

On balance, the Committee believes that the prospect is for a gradual recovery in the level of activity. The recession has probably impaired the supply capacity of the economy, but the scale and persistence of the fall in output means that a substantial margin of under-utilised resources is likely to remain for some time to come. That is likely to mean that inflation will fall below the target for a period.

The comparable passage in November was:

On balance, the Committee believes that the prospect is for a slow recovery in the level of economic activity, so that a substantial margin of under-utilised resources persists. That will continue to bear down on inflation for some time to come, offset in the short run by the impact of the past depreciation of sterling.

The changes are subtle but possibly significant. The Bank appears to be signalling that it underestimated supply-side damage from the financial crisis and recession, implying that the "output gap" – while "substantial" – is smaller than previously assumed. Accordingly, spare capacity is now judged likely to result in inflation declining "for a period" rather than "for some time to come". The Bank, however, continues to forecast a temporary undershoot of the target, although few will be convinced given its recent record.

The statement makes the following reference to the recent inflation surge:

CPI inflation has risen sharply to well above the 2% target, reaching 2.9% in December. That rise was largely accounted for by higher petrol price inflation and the reduction in the main VAT rate a year earlier dropping out of the calculation.

While it is true that December's sharp rise was largely due to petrol prices and the VAT base effect, it is highly misleading to suggest that the significant overshoot of the 2% target reflects these factors. The standard VAT rate was 15% in both December 2008 and December 2009, while core inflation – excluding food, alcohol and tobacco as well as petrol and other energy prices – has risen to an annual 2.8%.

The “credit counterparts” arithmetic shows how changes in the broad money supply, M4, are related to other components of the banking system’s balance sheet, including lending to the private and public sectors. Public sector lending – also termed the “public sector contribution” – has been much larger than the rise in M4 since March 2009, reflecting the Bank of England’s gilt-buying. This has led some commentators to claim that broad money will plunge if the purchase programme is stopped.

Such analysis, however, ignores important interactions between the credit counterparts. Official gilt-buying, while inflating public sector lending in recent months, has had simultaneous negative effects on other counterparts. The net boost to M4 has probably been modest, arguing against a significant negative impact from a suspension of purchases. With the demand to hold money depressed by negative real deposit rates, there should be sufficient monetary fuel to support an ongoing economic recovery.

The Bank’s gilt purchases can result in a negative impact on other credit counterparts in the following ways:

• An overseas investor selling to the Bank may hold the proceeds on deposit at a UK bank or use them to repay borrowing. This is recorded as a negative flow under “external and foreign currency counterparts”.

• A UK non-bank seller of gilts may repay bank borrowing or buy goods or assets from another UK resident who then repays debt. Bank lending to the private sector is correspondingly reduced.

• Alternatively, the non-bank seller may invest in newly-issued bank bonds or equities, resulting in a negative impact under “net non-deposit liabilities”.

• Official gilt purchases financed by the Bank creating reserves may cause banks to buy fewer gilts, since reserves are a close substitute. The rise in the public sector contribution is then smaller than the official purchases.

A reversal of the last effect may be particularly important in limiting any negative impact on M4 from a suspension of the Bank’s operations. Banks bought £26 billion of gilts between November 2008 and January 2009 but their holdings have risen by just £1 billion since the Bank announced its purchase scheme last February. A return to the earlier pace of accumulation would substitute for official buying on the recent scale.

A previous post argued that more favourable voter perceptions of the economy would result in a further narrowing of the Conservative poll lead over Labour near term, increasing fears of a hung parliament. This shift, however, would be reversed from early 2010, reflecting sharply-rising inflation. Economic factors, therefore, argued for Labour calling an early election rather than delaying until the last moment.

Recent polls support the first part of this forecast: the last five results reported on the excellent ukpollingreport.co.uk show a Tory lead of between 7 and 9 percentage points – below the 10 point gap widely regarded as necessary to guarantee a majority. Economic perceptions seem to be driving this move: the EU Commission's consumer confidence measure vaulted higher in January to its highest level since November 2007.

The earlier forecast was based on statistical analysis of Guardian / ICM polling data since the early 1980s. The results indicate that the position of the governing party relative to the main opposition depends positively on average earnings and house price growth and negatively on retail price inflation, unemployment and changes in interest rates – the chart shows fitted values of a model based on these factors.

According to this analysis, Labour is benefiting from rising house prices and the lagged impact of last year's low inflation while the labour market has become less negative, with unemployment and earnings growth stabilising. The model predicts a Tory lead of only 2 percentage points based on economic factors – the 7 to 9 point gap may reflect other influences that are working to Labour's disadvantage.

Labour strategists are counting on economic developments continuing to boost the party's support but the model suggests that the positive impact is peaking. On plausible assumptions about the inputs – including a rise in retail price inflation to 4-5% this spring – the poll gap is forecast to widen to 9 percentage points by May. If non-economic influences result in Labour continuing to underperform the model's predictions, this would be consistent with an outright Tory victory.

The fundamentalist wing of the monetarist school will be concerned by December money supply data, showing growth of only 1.1% in adjusted M4 (i.e. excluding holdings of non-bank financial intermediaries) over the last year and a small contraction over the latest three months. This weakness, however, is unlikely to signal an economic relapse because the demand to hold money has fallen in response to negative real interest rates and reviving confidence. Put differently, slow M4 expansion is being offset by a pick-up in the velocity of circulation, following a collapse before and during the financial crisis.

Key points:

The sectoral breakdown shows that weakness in adjusted M4 has been concentrated in the financial sector, with money holdings of insurance companies, pension funds and other investment managers down significantly since late 2008. This is likely to reflect a voluntary reduction in cash as institutions have become more confident about market prospects.

Non-financial M4 – i.e. money holdings of households and private non-financial corporations – rose by 2.6% in the year to December and at the same annualised rate over the latest three months.

The demand to hold money of households, like that of institutions, has been depressed by paltry yields and a revival of risk appetite. Household M4 rose by £23 billion during 2009 but retail inflows to unit trusts and OEICs are likely to have exceeded £25 billion (IMA figures for December are released tomorrow), up from just £4 billion in 2008.

Lower demand by institutions and households has allowed non-financial corporations to boost their liquidity despite slow aggregate money supply expansion. Corporate M4 rose by 4.2% in the year to December and by 6.2% annualised over the last three months. The liquidity ratio – sterling and foreign currency money holdings divided by bank borrowing – stabilised in December but has recovered significantly from its late 2008 low.

Broad money fundamentalists neglect a recent pick-up in narrow money M1 (notes and coin plus sight deposits), which rose an annual 7.2% in December. An increase in M1 relative to M4 is consistent with a recovery in velocity, with people shifting funds from savings accounts and time deposits into instant-access accounts in anticipation of increasing spending on goods and services or assets. M1 gave better warning of the recession than M4.

Bank rate is currently 1.9 percentage points below the annual increase in retail prices – the largest negative divergence since 1980. The shortfall will widen significantly further by the spring. The last sustained period of negative real rates, in the 1970s, was associated with a trend increase in M4 velocity – by 4.7% per annum on average over 1974-79. If velocity is embarking on another trend rise, slow broad money growth offers limited reassurance that inflation will return to target over the medium term.