The US monetary base rose again in the week to Wednesday, consistent with the forecast in Tuesday's post – see first chart. As previously discussed, markets have recently been sensitive to fluctuations in the base so this pick-up may support a near-term rally in equities, possibly accompanied by a weaker or stable dollar.

The reversal of the year-end contraction in the US monetary base may also have contributed to a recent resumption of capital inflows to Hong Kong. Under the currency board arrangement such inflows automatically expand the territory's own monetary base – first chart.

A post in October suggested that the Dow industrial index might follow a path similar to the recoveries after the 1906-07, 1919-21 and 1973-74 bear markets. The second chart provides an update: the Dow recently moved below the range spanned by the three rebounds, hinting at a buying opportunity.

One caveat to a positive view is that annual growth in G7 real money supply M1 is likely to cross below that of industrial output expansion this spring – historically, equities have underperformed cash on average under such circumstances. This analysis, however, allows for near-term market gains before the macro liquidity backdrop turns less favourable.

Markets are also concerned that China's policy tightening – banks' reserve requirement ratios were raised by a further 50 basis points today – will lead to a hard landing for its economy. This hinges on whether a large positive "output gap" has already developed – if so, much higher inflation is inevitable and the authorities will be forced to slam rather than tap on the brakes.

Output gap estimates are even flakier for China than elsewhere but two pieces of evidence suggest that the economy is not yet "overheating": industrial output is slightly below its trend over the last 10 years – third chart – while companies were not reporting skilled labour shortages late last year – fourth chart. A managed slowdown may still be possible.

The February Inflation Report is more dovish than expected but the Bank of England has failed to provide an explanation of the significant inflation overshoot relative to its forecasts, casting doubt on the credibility of its current projections. The suggestion is that the forecast is being adjusted to fit the policy rather than vice versa.

Key points:

• While forced to raise its near-term inflation profile, the Bank has revised down its medium-term forecasts: the two-year-ahead modal projection based on unchanged policies is now below 2% versus 2.35% in the November Report. It is difficult to believe that this change was warranted by the modest downward revision to its growth forecast, which continues to envisage a solid recovery.

• Governor King's claim that the current overshoot relative to the Bank's forecasts can be explained by higher energy prices is unconvincing. The February 2009 Report projected inflation of 1.3% in the first quarter of 2010 based on unchanged policies. If the Bank had used its current energy price assumptions, the forecast would have been about one percentage point higher, i.e. 2.3%. Inflation is now expected to be about 3.3% this quarter, despite a much larger GDP fall than the Bank predicted last February. In other words, there is an unexplained forecast error of at least a percentage point.

• The most likely explanation for this error is that the Bank overestimated the disinflationary impact of economic slack while underestimating upward pressure on traded goods prices from exchange rate depreciation. The cut in the medium-term inflation forecast, however, suggests that the emphasis on the "output gap" has, if anything, increased. The Bank, meanwhile, continues to assume that the impact of sterling weakness will be temporary; the alternative view is that the low real exchange rate will exert further upward pressure on UK goods prices relative to the global trend over the medium term.

• A likely significant rise in indirect taxes after the election will boost inflation relative to the Bank's forecasts. In a recent speech, Governor King suggested that the MPC would ignore "temporary price level factors" – defined to include commodity price rises, sterling depreciation and tax increases – when setting policy. It is debatable whether such an approach is compatible with the MPC's remit, which is to achieve the 2% target, defined by the consumer price index without any exclusions, "at all times".

A previous post argued that how the MPC interprets its remit would be as important for the interest rate outlook this year as the evolution of inflation and output. Today's Report reinforces suspicion of a shift to "inflation targeting lite", involving downplaying "exogenous" upward influences on inflation and placing more weight on forecasts and discretion. Accordingly, any policy tightening is now unlikely before May at the earliest.

The recent set-back in markets may partly reflect worries about a withdrawal of liquidity support by the Federal Reserve and other central banks. Such concerns are premature: the US monetary base is likely to reach a new high this spring.

The Fed plans to complete its purchases of about $1.425 trillion of agency debt and mortgage-backed securities by the end of March. As of last week, its balance sheet contained $1.135 trillion of such securities, implying $290 billion yet to be added.

Payment for this $290 billion will be made by crediting banks' reserve accounts at the Fed, which – together with currency – constitute the monetary base. Other things being equal, therefore, the base will rise from its current level of $2.037 trillion to $2.327 – a 14% increase.

The Fed, however, is simultaneously closing several liquidity support operations, including the term auction facility, the commercial paper funding facility and swap arrangements with other central banks. Lending under these facilities totalled $47 billion last week. In addition, banks may choose to repay the $16 billion of discount window loans still outstanding.

The $290 billion addition to the monetary base from securities purchases, therefore, will be offset by a repayment of up to $63 billion of emergency support, suggesting a net increase of $227 billion or 11% – see table.

The Fed, in theory, could sterilise this injection, by selling Treasury securities or running down "other" assets, asking the Treasury to hold more cash in its account, or conducting reverse repurchase agreements (included in "other" liabilities). Officials, however, are likely to view a further expansion of the monetary base as desirable given ongoing worries about the sustainability of the revival in the economy and markets.

A previous post suggested that consumer price inflation would rise to an annual 3.4% in January and average 3.2% in the first quarter. This now looks too high, for three reasons.

First, the British Retail Consortium (BRC) shop price survey for January showed a rise in non-food goods inflation from an annual 1.4% in December to 1.9% – smaller than expected given the return of the standard VAT rate to 17.5%. A larger proportion of retailers than previously thought may have either raised prices before January or absorbed the increase in margins, although the latter effect could prove temporary.

Secondly, CPI food inflation probably slowed in January. The annual increase in the BRC food price index fell from 3.7% in December to 2.9%. Similarly, producer output prices for food and beverages rose an annual 1.1% last month, down from 1.8% in December – see chart.

Thirdly, the 7% cut in gas tariffs by British Gas – effective immediately – is likely to be followed by other suppliers over coming weeks, implying a reduction of 0.15% in the CPI.

Petrol prices will have a large upward effect – an estimated 0.25 percentage points – on the CPI annual rate in January, reflecting both a rise last month, partly due to the VAT hike, and a fall in January 2009.

Based on the above, CPI inflation may rise to an annual 3.2% in January before falling back to 2.9% in February and March, implying a first-quarter average of 3.0%.

Bank of England Governor Mervyn King will be able to explain a move above 3% as the result of the VAT hike and petrol price effects. The bigger issue is the stickiness of "core" price trends: the CPI excluding unprocessed food and energy rose by 2.9% in the year to December and at a similar annualised rate over the last three months (adjusting for seasonal influences).

With the economy recovering, the "output gap" smaller than generally assumed and the weak exchange rate exerting upward pressure on goods prices, core inflation may continue to frustrate MPC and consensus hopes of a significant slowdown. Coupled with further indirect tax hikes after the election, this may keep headline CPI inflation well above the 2% target for the foreseeable future.