The US monetary base (currency plus bank reserves) rose again in the week to Wednesday and is now up by 3.7% from its low a fortnight ago, following a 9.4% contraction between late February and early May. A recovery in the monetary base preceded a rally in equities by three weeks in February / March 2009, by two weeks in June / July and by four weeks in January / February this year – see first chart.

The Eurozone monetary base also rose in the week to last Friday and is up 9.7% since late April – first chart.

Some measures of equity market sentiment look extremely oversold. The Chicago Board Options Exchange equity put / call ratio, for example, is at its highest level since the bear market ended last March – second chart.

The sustainability of any rally in equities may depend on whether central banks continue to expand liquidity. The Fed may be reluctant to reverse fully the earlier contraction of the monetary base unless it believes that market turbulence is a serious threat to the economic recovery. The impact on the base of its dollar swap lending to European central banks has so far proved small – the ECB's 84-day tender of dollars this week attracted bids of only $1.0 billion. The ECB, meanwhile, continues to state that it will sterilise the liquidity effect of its "non-standard" measures.

A signal that the Fed was turning more expansionary would be an announcement of a reduction in the "supplementary financing programme", under which the Treasury has issued an additional $200 billion of bills, placing the proceeds in a special account at the central bank. The Treasury could repay maturing bills by running down the balance in this account, thereby boosting bank reserves and the monetary base.

A further reason for caution about any rally is the still-unfavourable balance between global economic and monetary growth. G7 real narrow money, M1, is continuing to expand more slowly than industrial output – third chart.

The fourth chart shows regional equity market performance, including currency, relative to the World index. Europe ex. the UK has underperformed significantly so far this year but the price relative has made higher lows recently, hinting at a turnaround. Extreme investor pessimism about Europe and the euro is already reflected in positioning, while real M1 is growing faster in the Eurozone than in the US, Japan and UK.

The Dow Jones industrial average fell by 54% between October 2007 and March 2009. There were seven declines in the Dow of 45% or more during the last century – see table. Six of the seven were in a range of 45-55%, the exception being the 89% fall between September 1929 and July 1932.

The chart compares the recovery in the Dow from its trough on 9 March 2009 with the rallies following these six prior bear markets, excluding the 1929-32 decline. The low of each bear was rebased and aligned with the March 2009 trough. The chart shows mean performance and the range across these prior falls and recoveries.

The Dow has been mostly ahead of the average since the March low, sometimes even straying above the range spanned by the prior rallies. This may reflect the unprecedented monetary stimulus unleashed by the Federal Reserve and other central banks amid the post-Lehman crisis. Also, the October 2007-March 2009 decline was slightly larger than the average (54% versus 48%), possibly contributing to a stronger recovery.

As the liquidity backdrop has deteriorated, however, the Dow has converged with the six-bear mean, closing marginally below it yesterday.

The average suggests that equity performance over the next year will be much less impressive than during the first 12 months of the rally. The level of the average at the end of June 2011 is 8% above yesterday's Dow close.

The chart, however, also shows that the range of performance during the second year of recoveries has been much wider than in the first. The "best-case" historical scenario would involve the Dow reaching 16,000 early next year. The minimum suggested level is 8,800 – still 34% above the 6,547 low reached last March.

Based on liquidity analysis, a fall into the lower half of the historical range seems more likely in the short term than renewed strength. With economic recovery expected to be sustained into 2011, however, a significant undershoot of the average could present another buying opportunity – especially if current turbulence forces central bank easing.

Posts over the last year have argued, probably ad nauseam, that Bank of England and consensus inflation forecasts were too low. April figures delivered another unfavourable "surprise", with the headline CPI and RPI rates moving up to 3.7% and 5.3% respectively. RPI inflation is now at its highest level since the aftermath of the late 1980s Lawson boom.

Governor King's latest explanatory letter claims that the overshoot of CPI inflation relative to the 2% target is fully explained by higher oil prices, the rise in VAT and exchange rate weakness. This is dubious. Energy and VAT are unlikely to account for more than 1 percentage point of the 3.7% April headline rate. Sterling's decline partly reflects monetary policy decisions so the Bank cannot absolve itself from responsibility for the impact on inflation.

The Governor also fails to acknowledge the scale of the Bank's forecasting error. The central projection in the May 2009 Inflation Report was for CPI inflation to fall to 0.7% by the second quarter of this year. This incorporated the planned VAT rise and was based on a similar effective exchange rate level to today's. Higher energy prices can account for only about 0.5 of a percentage point of the 3 point forecast miss.

The Bank's error was to place too much weight on the "output gap" as a driver of inflation while underestimating the impact of sterling's decline to significantly undervalued levels. It also wrongly believed that low money supply growth would constrain price rises, neglecting that the demand to hold money had been depressed by its imposition of negative real interest rates. The lessons, however, have yet to be learnt, judging from the letter and the latest Inflation Report.

The charts present updated CPI and RPI inflation projections. They incorporate, optimistically, a significant slowdown in core price rises from their recent pace in response to economic slack and smaller import price gains. A hike in the standard VAT rate to 20% is assumed in January 2011, possibly to be pre-announced in the June emergency Budget, while the RPI profile posits an increase in Bank rate to 2.5% by mid-2011. Headline CPI and RPI rates may have peaked in April but are forecast to remain elevated, averaging 3.0% and 4.6% respectively between May 2010 and December 2011. The latest Inflation Report projections are barely more credible than those issued a year ago.

Previous posts have argued that the escalation of the Eurozone sovereign debt crisis and associated weakness in equity markets reflected deteriorating global liquidity conditions. One aspect of this deterioration was a 9.4% contraction in the US monetary base (currency and bank reserves) between late February and early May – see chart.

A key issue for markets, therefore, is whether the crisis results in a significant reinjection of liquidity by central banks. A post last week suggested that the US and Eurozone monetary bases would expand but by less than needed to recreate bull market conditions. The Fed's response seemed likely to be constrained by strong domestic economic news while the ECB had signalled its intention of sterilising the impact of its bond purchases.

The latest US figures confirm that the Fed has injected liquidity in response to the crisis, resulting in a 2.3% rise in the monetary base in the week to Wednesday – the first increase for seven weeks. This was achieved by the Treasury running down its cash balance at the Fed. Currency swap lending to European central banks should result in a further rise in the base this week. The Fed, however, is unlikely to wish fully to reverse its earlier liquidity withdrawal.

Eurozone monetary base figures for last week – released tomorrow – will be boosted by the six-month repo operation conducted on Wednesday, at which the ECB lent €35.7 billion (equivalent to 2.8% of the monetary base), and the initial impact of its bond purchases. The ECB's claim that it will sterilise its bond-buying is suspect since it has limited control of the monetary base as long as repo lending is on a full-allotment basis.

Central bank liquidity injections could be laying the foundation for a bottom in equities and other risk assets but caution remains warranted until the US / Eurozone monetary base show more significant and sustained expansion. Note, also, that prior US market troughs over the last 18 months have occurred several weeks after the low in the monetary base – see chart.