Federal Reserve Chairman Ben Bernanke this week delivered a more upbeat assessment of US economic prospects while – in response to questioning – repeating the mantra that very low official rates will be needed for an "extended" period. Markets, however, may be wrong to assume that this implies no policy tightening until late 2010 at the earliest.

The Fed's management of its balance sheet, indeed, suggests that a policy reversal has already started. The monetary base – currency plus banks' reserve balances at the Fed – has fallen by 6.0% over the last seven weeks. This reflects the impact of the "supplementary financing programme" (SFP) under which the Treasury issues additional bills and deposits the proceeds in its account at the Fed, resulting in a reduction in bank reserves.

Monetary base movements have recently led equity market fluctuations – see Andy Kessler's Wall Street Journal article and the first chart below.

The SFP is now up to $175 billion of a targeted $200 billion, suggesting that its negative impact on the monetary base will abate. The Fed, however, could request a further expansion of the programme or use other methods to continue to drain reserves, such as reverse repurchase agreements or auctions of term deposits.

In an earlier speech on the Fed's exit strategy, Chairman Bernanke suggested that the first stage of a tightening process would be a liquidity-draining operation designed to align market interest rates with the officially-set rate paid on reserve balances, currently 0.25%. The second stage would be a hike in the reserves rate. Consistent with this plan, the effective Fed funds rate has risen from a range of 0.10-0.14% in January and February to 0.20% as the monetary base has contracted – second chart.

The cautionary message for equities and other risk assets from the Fed's apparent policy shift is reinforced by a recent cross-over of G7 annual industrial output growth above real narrow money expansion – third chart. As previously discussed, global equities have underperformed cash by 5% per annum on average since 1970 when production has outpaced real M1, outperforming by 11% pa at other times.

A previous post argued that a January speech by Bank of England Governor Mervyn King signalled a change in the Monetary Policy Committee's interpretation of its remit. Instead of targeting a 2% annual rise in consumer prices "at all times", policy-makers would focus on the Bank's forecast for an unspecified "core" inflation measure, excluding "temporary price level factors". The post suggested that this amounted to a de facto raising of the target from 2% to perhaps 3%.

Markets, it appears, agree that the Bank's inflation-fighting commitment has softened. The yield gap between conventional and index-linked gilts of between five and 15 years' maturity – a proxy for long-term market inflation expectations – has risen by 50 basis points (bp) since the February Inflation Report, which confirmed the dovish message of the Governor's speech. US market-implied inflation expectations are little changed over the same period  – see first chart.

The UK yield spread is now 50 bp above the average over the last 10 years and at its highest since September 2008. It is above the levels reached before sustained increases in official interest rates starting in 2003 and 2006 – see second chart. With growth accelerating, asset prices buoyant and sterling raw material costs soaring, the Bank should already have started to withdraw emergency stimulus. Markets may yet force an earlier and larger rise in rates than most expect.

Combined industrial output in the G7 and seven large emerging economies (the "E7") – a proxy for global activity – rose by a further 0.5% in February, to stand only 4% below its February 2008 peak. Output has rebounded by 12% since February last year, following a 14% peak-to-trough decline. Leading indicators signal a further solid gain into the summer – see chart.