The May Inflation Report marks another step towards the demise of inflation-targeting. In a now-familiar routine, the Bank has been forced to raise its near-term inflation forecast significantly but continues to project an eventual decline to below the 2% target, based on a “neo-Keynesian” model emphasising the “output gap” and future fiscal tightening. A recent rise in inflation expectations is downplayed while the alternative “monetarist” view that persistent inflation overshoots reflect an excess of the supply of money over the demand to hold it – with demand depressed by the Bank’s imposition of negative real interest rates – is ignored. The message is that monetary policy, in effect, will be set to accommodate overborrowers, both private and public. Bank and building-society savers can expect a further erosion of their real wealth as post-tax deposit rates remain below "surprisingly resilient" inflation.

Key observations:

• The Governor suggested that the forecast was little changed from February but the inflation numbers are significantly higher out to the third quarter of 2011. The central projection for the current quarter appears to be 3.3%, up from 2.8% in the February Report, while the trough now occurs at about 1.5% in the second quarter of next year versus 0.9% in the first quarter previously (based on unchanged policy).

• The two-year-ahead projection, as in February, is just below the 2% target but with risks tilted slightly to the upside, signalling that the MPC remains firmly in neutral. The careful calibration suggests that this is more an assumption than an evidence-based forecast.

• The Bank remains bullish on the recovery, probably justifiably. The central projection is for GDP to rise by about 7.5% over the next two years (unchanged policy), although with downside risks, so the mean forecast is about 6.5%. On the defensible view that the "output gap" may be only 2% of GDP while potential growth may have fallen to about 2%, spare capacity could be eliminated by late next year. (The Bank, of course, refuses to disclose its own estimates of the "gap".)

• The chart compares quarterly inflation with the Bank's central projection a year earlier (unchanged policy). Since 2005, inflation has exceeded the forecast in 17 out of 21 quarters, with a mean error of 0.5 of a percentage point.

• The inflation target was switched from RPIX to the CPI in December 2003. Since then, the CPI has risen at an average rate of 2.5% per annum versus the 2% target while RPIX has increased by 3.1% pa versus the previous 2.5% target. Expressed differently, the level of the CPI today is 3.0% higher than if the 2% target had been achieved on average.

The Chinese authorities have been attempting to tighten monetary policy without raising interest rates or allowing the exchange rate to appreciate. The latest inflation and monetary statistics suggest that their efforts are failing.

Consumer prices rose by 2.8% in the year to April and at a seasonally-adjusted annualised rate of 3.9% over the last three months – see first chart. If this latter rate of increase is maintained, annual inflation will reach 4.0% in August and average 3.2% in 2010, above the 3% target – green line in chart.

Momentum, however, is likely to accelerate further. Chinese inflation follows swings in narrow money, M1, growth – second chart. The annual M1 increase reached a 17-year high of 39% in January and was still 31% in April. Shorter-term growth also remains buoyant – 30% annualised over the last six months. Historically, these rates of expansion have been associated with 20%-plus inflation.

Administrative controls and "moral suasion" have resulted in a more significant slowdown in credit and broad money, M2. Six-month growth rates, however, remain solid, at 18% and 19% annualised respectively. The demand to hold M2, moreover, has probably fallen as inflation has moved above deposit rates. M1 is a measure of transactions rather than savings money and should be a better leading indicator of activity and price pressures.

The prospect of more significant Chinese policy tightening is a further reason for caution about the liquidity backdrop for markets.

Q. Does the Eurozone rescue package change the liquidity backdrop for markets from negative to positive?

A. Possible but doubtful. Most of the package (EU budget funding, Eurozone intra-government loans / guarantees, IMF contribution) has no direct implication for liquidity. The key issues are the scale of ECB government bond purchases and the impact of its expanded lending operations and the US dollar swap on the Eurozone and US monetary base. 

• The ECB states that bond-buying is intended "to ensure depth and liquidity in those market segments which are dysfunctional". It has given no indication of the possible scale of purchases, in contrast to the Fed and the Bank of England when they embarked on QE.

• Buying must be large to have a significant impact on global liquidity. To boost G7 broad money by 1 percentage point (pp), Eurozone M3 would need to rise by about 3 pp. Assuming a one-for-one impact of bond-buying on the money supply, this would require purchases of €280 billion. (This compares with the ECB's covered bond purchase programme, announced in May 2009, of €60 billion.)

• The scale of intervention by the Fed to stabilise the US mortgage-backed securities (MBS) market also suggests that large-scale buying will be required. The Fed purchased $1.25 trillion of agency MBS, equivalent to about 25% of the outstanding stock. To buy 25% of outstanding government debt in the PIIGS (Portugal, Ireland, Italy, Greece and Spain) markets, the ECB would need to spend €420 billion.

• The ECB has indicated that its bond purchases will be sterilised but the Eurozone monetary base may nonetheless expand because of the simultaneous decision to reintroduce full-allotment three- and six-month repo operations. In contrast to the US and UK QE variants, however, there is no explicit aim to boost banks' reserves.

• The US dollar swap arrangements with the Fed have the potential to increase the US monetary base. The Fed, however, has been draining bank reserves in recent weeks, probably in response to stronger economic news, suggesting that any expansionary impact from swap lending will be sterilised.

Conclusion: The rescue package will suppress contagion and ease near-term financing but does not remove longer-term solvency concerns based on doubts about the willingness of electorates in the PIIGS to accept fiscal stringency. There is a risk that investors will use a bounce in prices to accelerate capital withdrawal. Central bank actions have the potential to be a "game-changer" in terms of the liquidity backdrop for markets but the ECB's reluctance to quantify bond-buying and its bias towards sterilisation argue for caution. A more positive interpretation would be warranted in the event of an early significant pick-up in the Eurozone and US monetary base.