If the consumer price index is to be believed, the volume of spending by the British public on clothing and footwear is nearly three and a half times its level in 1997.

The cash value of spending rose by two-thirds between the first quarters of 1997 and 2010. According to the CPI, however, clothing and footwear prices have fallen by 51% over this period, implying an increase in the volume of spending of 243%.

The national accounts measure of the volume of spending on clothing and footwear, based on retail price rather than CPI methodology, shows a smaller rise, of 130%. This still equates to a solid 6.6% annualised rate of increase. The CPI-based measure suggests that spending volume has grown by 9.9% per annum. Absent evidence of a boom in wardrobe sales, this looks implausible.

This example highlights the significant divergence between CPI and RPI inflation caused by the former's use of geometric rather than arithmetic means to combine price changes of individual items. Geometric means are always lower, with the shortfall increasing with dispersion among components. Proponents of the geometric approach argue that it captures "substitution" between cheaper and more expensive goods as prices changes. The arithmetic mean, however, correctly measures the changing cost of a fixed basket of products.

Clothing and footwear prices rose by 6.3% in the year to June according to the RPI but fell by 1.4% if the CPI is to be believed. The difference subtracted 0.4 percentage points from headline CPI inflation in June. This is larger than the average 0.2 pp effect over the five years to 2009, reflecting a decision this year to use more quotes for each item, with resulting wider price change dispersion further lowering geometric mean inflation relative to the arithmetic mean.

The total "formula effect" wedge between CPI and RPI inflation, incorporating differences in other index components, was 0.8 percentage points in June – see chart.

A central bank's key responsibility is to preserve the real value of money. Consumers on fixed incomes or with fixed savings are understandably sceptical about the "substitution" argument and believe that RPI inflation is a better guide to the erosion of their purchasing power. They have been abandoned by the Bank of England, which has failed to prevent high inflation even on the weaker CPI measure. The coalition government now plans to effect a further transfer of wealth by imposing CPI- rather than RPI-linking on pensioners, benefit recipients and wage-earners.

Failure to protect the purchasing power of money reinforces the incentive to borrow rather than save and invest, thereby preventing necessary economic "rebalancing".

The EU / IMF rescue package for Greece has failed to stem an outflow of funds from the country's banking system, according to Bank of Greece balance sheet data.

To bridge the funding gap, the central bank was forced to boost its lending to Greek banks from €93.8 billion at the end of June to €96.2 billion at end-July. Banks, meanwhile, reduced their deposits with the Bank of Greece from €10.0 billion to €7.5 billion, resulting in a combined transfer of €4.9 billion from the central bank.

Lending support of €96.2 billion at the end of July implies that the Bank of Greece is funding about 15% of Greek banks' assets. The ECB has acquired additional exposure to Greece, of perhaps €25 billion, via purchases of government bonds under its securities markets programme.

Lending to Greek banks now exceeds the €94.8 billion of loans extended by the Central Bank of Ireland to the Irish banking system as of the end of June. (The Irish figure is inflated by lending to foreign banks located in Dublin's international financial services centre.)

The ongoing loss of funds may revive concerns about the stability of the Greek banking system. Banks' ability to obtain additional ECB funding may eventually be limited by a shortage of eligible collateral.

The useful information in each Inflation Report is summarised by a single statistic – the Bank of England's mean forecast for inflation in two years' time based on unchanged policies. The deviation of this forecast from the 2% inflation target is a measure of the MPC's bias to tighten or loosen policy. (The rest of the Report contains much interesting material but has rarely proved useful, based on the Bank's forecasting record.)

The mean two-year-ahead forecast in the May Inflation Report was 2.04%, indicating that the MPC intended to maintain current policy for some time while envisaging an eventual need for very modest tightening. The projection appears to have been lowered to just below 2.0% in the August Report, judging from the fan chart (the Bank refuses to publish numbers until a week after the Report itself). The MPC, therefore, is signalling continued near-term inaction but now views further easing – presumably in the form of additional asset purchases – as marginally more likely to be necessary than any tightening.

This change has occurred despite inflation again overshooting the Bank's forecast three months ago by a significant margin. The new fan chart suggests that inflation will average 3.0-3.1% in the current quarter, up from 2.6% projected in May. This overshoot is strong prima facie evidence that spare capacity has failed to exert the disinflationary influence expected by the Bank but the capacity argument was again wheeled out by Governor King as a favoured deus ex machina to justify his continued assertion that inflation will eventually fall back to below the target.

As widely expected, GDP growth projections for 2011 and 2012 were lowered, with the fan chart suggesting a mean forecast on unchanged policies of about 2.4% next year versus 3.1% in May (note, though, that 2010 has been revised up from 1.4% to 1.5-1.6%). However, the reasons given for the downgrade – recent weaker surveys, tighter-than-expected credit conditions and larger-scale fiscal tightening – are unconvincing. The Governor himself argued that the fiscal effect was marginal while evidence on credit conditions has been mixed – the CBI's July survey of smaller manufacturing companies reported that the percentage of firms citing credit or finance as a constraint on output had fallen back to its long-run average.

The suspicion is that the MPC has been spooked by double-dip talk and has taken the opportunity to lower an over-optimistic previous growth forecast, with this downgrade providing a fig-leaf for maintaining the projection of a large fall in inflation over the medium term. Policy inaction can, thereby, be justified for a while longer, to the relief of Chancellor Osborne. The Bank, however, may face a rendezvous with reality later this year as the economy defies double-dip pessimism and a continued inflation overshoot leads to a further "unanchoring" of inflationary expectations.

Inflation targeting supposedly involves the Bank of England using its huge intellectual capabilities to produce a forecast for inflation one to two years ahead and then adjusting policy to minimise deviations of the forecast from the 2% objective. This procedure has become meaningless, for two reasons.

First, the Bank's forecasts have little information content, as documented by an article in today's Financial Times. The chart illustrates the persistent tendency to underpredict inflation in recent years.

Secondly, the MPC appears to be more exercised by the "tail risk" of deflation than a persistent inflation overshoot, although such a bias is at odds with its remit. The Committee, in effect, is setting policy to avoid a deflationary scenario rather than taking into account the full probability distribution of future inflation outcomes.

A cynical view is that the emphasis on deflationary risks is a smokescreen to allow super-low interest rates to be maintained in order to meet objectives unrelated to the inflation target, such as providing cover for fiscal policy tightening and suppressing the exchange rate in the hope of promoting "economic rebalancing".

Against this backdrop, it would be a surprise if tomorrow's Inflation Report failed to follow the recent pattern of revising up near-term inflation projections significantly while forecasting a fall to below the 2% target in two years' time, with a sufficiently wide distribution around this forecast to allow MPC doves to continue to emphasise deflationary risks.

It would be even more surprising if markets reacted to the Bank's increasingly irrelevant musings.

Some well-known "monetarist" economists and commentators continue to cite weak broad money trends as a reason for fearing renewed recession and deflation. They were making similar claims a year ago. A post last September argued that the worries were overdone because a rise in the velocity of circulation was likely to compensate for sluggish monetary expansion.

In terms of Irving Fisher's "equation of exchange" MV = PY, MV would rise respectably as velocity V reversed its large fall during the recession, resulting in both higher prices P (i.e. no deflation) and growth in real output Y.

A rise in velocity was expected because central bank policy easing had resulted in interest rates on bank deposits falling to historically low levels that, moreover, failed to compensate for inflation and taxes. Consumers and companies, therefore, would seek to economise on money holdings, leading to increased investment in other financial assets and, ultimately, higher spending on goods and services.

The chart shows annual rates of change of US and UK broad money velocity, defined from the Fisher equation as PY / M, with P = consumer prices and Y = real GDP. The money supply measures used were M2 for the US and M4 excluding money holdings of non-bank financial intermediaries for the UK. Consistent with the forecast, velocity rose by 3.2% in the US and by 4.0% in the UK in the year to the second quarter – the largest annual increases since 1995 and 1980 respectively.

US M2 and UK M4 grew by only 1.7% and 1.1% in the year to the second quarter but the latest three-month rates of increase are stronger, at 6.3% and 6.0% annualised respectively (M2 as of 26 July, M4 as of June). With velocity likely to continue to trend higher until central banks normalise interest rates, current broad money trends appear consistent with further solid expansion of nominal output PY.