There is growing acceptance that high UK inflation cannot be explained simply as the result of a series of adverse one-off factors, as claimed by Bank of England Governor Mervyn King in recent explanatory letters. External Monetary Policy Committee (MPC) member Andrew Sentance has linked the overshoot to a surprisingly strong recovery in nominal spending, while his colleague Adam Posen argues that inflationary expectations have become dislodged from the target. Is there a fundamental driver linking these views?

Previous posts have argued that the root cause of disappointing inflation performance has been an excess of the supply of money over the demand to hold it. An attempt by consumers and firms to eliminate this surplus has contributed to the pick-up in nominal spending; an environment of excess liquidity may also have made it easier for companies to pass on higher costs while increasing unease about inflation prospects.

Most economists with monetarist leanings have dismissed the possibility of such an imbalance because of the slow pace of broad money supply expansion in 2008-09. The surplus, however, is the result not of an excessive rise in supply but rather a fall in demand, as negative real deposit rates have encouraged investors to rebalance portfolios away from money into assets offering a higher yield and / or inflation protection.

To the extent that the possibility of a decline in money demand is acknowledged, the consensus is that this represents a one-off shift, implying no lasting economic implications. Such a view, however, is at odds with experience in the 1970s, when a fall in the ratio of money to national income was sustained for several years as the monetary authorities, as now, maintained official interest rates well below the rate of price increases.

A pick-up in money supply expansion, moreover, could now be taking over from declining demand as the key driver of surplus liquidity. The Bank's favoured broad money measure, M4 excluding holdings of non-bank financial intermediaries, rose at an annualised rate of the 9.2% in the three months to May, the fastest since the third quarter of 2007 – see chart.

The consensus is that this pick-up will, again, prove temporary because bank lending to the private sector remains weak. Money and lending, however, can, on occasions, diverge significantly. One possibility is that the combination of Eurozone stability worries, an undervalued exchange rate and the coalition’s early action to tackle the fiscal deficit will result in a sustained inflow of foreign capital into the UK. A combined surplus on the current and non-bank capital accounts of the balance of payments will, other things being equal, expand the money supply relative to private sector lending. Recent strong foreign buying of gilts and Treasury bills could be an early indication of such an inflow.

The risk, therefore, is that the supply of money will continue to run ahead of monetary demand, with the excess sustaining faster nominal spending growth and higher inflationary expectations. The neo-Keynesian MPC is relying on fiscal tightening to slow nominal income expansion but it may simply result in a less favourable real growth / inflation split, particularly in view of the VAT rise and other tax increases planned for next year.

On this analysis, there is little prospect, on current policies, of inflation returning sustainably to target. An early rise in official interest rates is warranted, not to choke off faster money supply expansion but rather to boost demand to eliminate surplus liquidity. Higher rates would further increase the UK’s attractions to foreign investors, with an increased capital inflow likely to put upward pressure on the exchange rate and partially offset the impact of a rise in the demand to hold money on the monetary imbalance. An appreciation of sterling, however, may be needed to reverse the recent upward drift in inflationary expectations and allow a more favourable real growth / inflation division of nominal income expansion.

You don't have to be a Keynesian to worry about the recent Budget.

There is no dispute that immediate fiscal tightening is required but the previous government's plans already implied a fall in the "structural" current deficit from 5.3% of GDP in 2009-10 to 1.6% by 2014-15, with an additional 2.3 percentage point cut in net investment. Chancellor Osborne could have concentrated on filling in the detail of proposed spending restraint while signalling that further action would be taken to achieve his new fiscal "mandate" of current balance by the end of the parliament, i.e. in 2015-16.
 
The Budget, instead, targets a much faster adjustment and a structural current surplus of 0.8% of GDP in 2015-16, implying overachievement relative to the mandate, probably to create scope for largesse in the run-up to the next election. There is a direct link between this target and the decision to raise the standard VAT rate from 17.5% to 20% from January 2011 – 0.8% of GDP implies a cash surplus of £15 billion in 2015-16 while the VAT hike is projected to raise £14 billion in that year.
 
The impact of fiscal tightening on growth is uncertain but there is credible evidence that tax increases inflict significantly more damage than cuts in current spending. It may be wrong, moreover, to assume that indirect tax hikes harm incentives less than rises in direct taxation: higher VAT boosts the marginal tax rate on consumed income and consumption, presumably, is the ultimate aim of most work and investment. (The 2011 VAT increase, representing a permanent change, should have a much larger economic impact than the recent rise, which reversed a temporary cut.)
 
The Chancellor estimates that expenditure reductions will account for 77% of total consolidation by 2015-16 but the proportion is smaller in earlier years – only 57% by 2011-12. The VAT hike and tax rises announced by the previous government are projected to raise £14 billion, equivalent to 0.9% of GDP, next year. Early spending cuts, moreover, are focused not on current outlays but rather investment – projected to fall by 16% and 20% in real terms in 2010-11 and 2011-12 respectively.
 
Fiscal risks to growth, however, do not imply that the Monetary Policy Committee (MPC) should refrain from normalising interest rates, if it is serious about meeting the inflation target. MPC member Adam Posen recently argued that the current overshoot partly reflects an "unanchoring of inflation expectations"; these may be further destabilised by the coming VAT hike. Until the Bank acts to reverse this drift, high inflation may continue to coexist with a sluggish economy.

The relationship between the US monetary base (i.e. currency plus bank reserves) and equities identified by Andy Kessler and discussed in previous posts remains intact. The fall in the US market from a temporary rally peak in mid June followed a renewed decline in the monetary base starting about a month earlier, continuing last week – see chart.

The Eurozone monetary base, meanwhile, will have contracted significantly last week as banks repaid ECB loans – figures are released on Wednesday.

Recent US dollar weakness may partly reflect expectations that the Federal Reserve will respond to rising financial / economic risks by reinjecting reserves. One possibility is a suspension of the "supplementary financing program" (SFP) under which the Treasury has issued an additional $200 billion of Treasury bills and onlent the proceeds to the Fed. The SFP was the main reason for the contraction in the monetary base between late February and early May. A reversal would involve the central bank creating new bank reserves to repay the Treasury and, in turn, bill investors.

Caution, however, remains warranted until such a policy change is confirmed.

Recent stock market weakness was signalled by a rise in G7 annual industrial output growth above real narrow money, M1, expansion in February. Since 1969, world equities have underperformed US dollar cash by 5% per annum on average when output has grown more strongly than real M1, while outperforming by 11% pa when there has been "excess" money – see charts and earlier post for more discussion.

Between the end of March, when the February output / real money growth cross-over was known, and the end of June, equities underperformed cash by 13% (not annualised).

Based on partial data, G7 industrial output growth was an annual 10% in May versus a 5% increase in real M1. Equities may struggle to mount a sustained rally until this gap closes.

G7 output momentum has been expected to slow during the second half, based on monetary trends and history. This prospect has been confirmed by recent softer business surveys. A "soft landing" scenario might involve annual industrial growth moving down to below 5% by year-end.

If annual real M1 expansion were to stabilise at 5%, therefore, the money / output relationship could generate another "buy" signal in late 2010.

A "double dip", of course, would hasten a new cross-over of industrial growth beneath real money expansion. In this scenario, however, "excess" money would probably flow into high-grade bonds and other "safe havens" rather than equities, which would suffer from earnings weakness. (A temporary slowdown rather than a double dip will remain the central case here unless real M1 contracts.)