US deflation fears have been fanned by a fall in annual core CPI inflation – excluding food and energy – to 0.9%, the lowest since 1966. The decline, however, from 2.4% when the recession started in December 2007 is entirely explained by the "shelter" component. Excluding shelter, core inflation was an annual 2.0% versus 1.9% in December 2007 – see chart.

Shelter has a 42% weight in the core CPI while 78% of the shelter component is accounted for by "owners' equivalent rent" (OER) – statisticians' estimate of what homeowners would pay if they rented their properties. OER inflation has fallen from an annual 2.8% in December 2007 to -0.2% by July. To repeat, no consumer actually pays OER.

OER inflation tends to follow house price inflation with a lag. The 12-month rate of change of the Case-Shiller 20-city house price index has recovered from a trough of -19% in January 2009 to 5% by May this year. OER has started rising recently, with a 0.7% annualised gain in the three months to July. Allowing for the normal lag, this recovery may be sustained over the remainder of 2010, putting upward pressure on core inflation.

The consensus interpretation is that US core inflation, unlike its UK counterpart, has been responsive to a large negative "output gap". The rise in the core ex. shelter measure since the beginning of the recession casts doubt on this view. Even in the US, it seems that the disinflationary impact of economic slack has been small and offset by other factors, including "QE", via its effects on the exchange rate and inflationary expectations. 

Posts earlier in the year argued that global economic momentum would fade in the second half in lagged response to narrow money supply weakness in late 2009 and early 2010. A slowdown would also be consistent with the typical cyclical pattern, involving strong stocks-led growth in the first year of a recovery followed by a "resting phase" before a sustained upswing driven by final demand.

The US Institute for Supply Management (ISM) manufacturing new orders index is a useful summary measure of global industrial momentum. A chart presented in a post in June suggested that this index, then at a recovery peak of 66, would fall back to the break-even 50 level over the summer. An update is provided in the first chart below – ISM new orders dropped to 53 in July and this week's regional manufacturing surveys by the New York and Philadelphia Federal Reserve Banks suggest a further decline in August.

If the index continues to follow the "five-cycle average", it may stabilise at around the 50 level before restrengthening in early 2011. It would need to fall to 45 or below to signal a recession. Sub-45 readings have historically been preceded by a significant contraction in US real narrow money but this has expanded recently – second chart. A further indication that the ISM measure may be approaching a trough is a small rise this month in the Philadephia Fed future orders index (in contrast to the decline its current orders measure) – third chart.

The latest public finances numbers remain consistent with a substantial undershoot of the Office for Budget Responsibility (OBR) forecast of net borrowing of £149 billion in 2010-11 (excluding the temporary impact of financial interventions).

Attempting to adjust for seasonal factors, borrowing averaged about £12 billion in the first four months of the fiscal year, or £144 billion annualised – see chart. The OBR forecast, therefore, implies a worsening over the remainder of 2010-11.

This is unlikely because, first, the benefits of economic recovery should grow as the year progresses and, secondly, the coalition has announced £8.1 billion of spending cuts and tax rises in 2010-11, most of which has yet to take effect. Put differently, even assuming no further impact from an improving economy, these measures together with the recent run-rate imply borrowing of £136 billion this year (i.e. £144 billion minus £8 billion), £13 billion less than the OBR's forecast.

The evolving undershoot increases doubts about the wisdom of the coming VAT rise – projected to raise £2.9 billion and £12.1 billion in 2010-11 and 2011-12 respectively. This increase threatens to weaken the economic recovery and was not strictly necessary to meet the new fiscal target of current budget balance by the end of the parliament, even according to the OBR's June forecast.

The fall in annual consumer price inflation from 3.2% in June to 3.1% in July reflected a larger decline in the "core" rate – excluding energy, food, alcohol and tobacco – from 3.1% to 2.6%, offset by a rise in food inflation from 1.7% to 3.0%. The core number was a favourable surprise but the impact on the near-term inflation outlook is offset by the likelihood that food price rises will remain stronger than previously expected, given recent increases in raw commodity costs.

Incorporating today's figures, CPI inflation is projected to ease back below 3.0% over coming months before moving up to this level again in early 2011 as the standard VAT rate is raised to 20% – see chart. This implies that Bank of England Governor Mervyn King may avoid having to write a fourth explanatory letter to the Chancellor this year. The VAT hike is expected to boost annual inflation because consumer-facing companies are expected to pass on a greater proportion of the 2.5 percentage point increase than for the identical rise in January 2010, partly because the latter was a reversal of a previous cut.

The Bank of England's modal forecast in the August Inflation Report is similar to the profile shown in the chart until next spring but the Bank then expects a sustained decline to below the 2% target in 2012. This is partly explained by the mechanical effect of the VAT rise dropping out of the annual comparison but the Bank is also assuming a significant fall in core inflation as a lagged consequence of the large-scale spare capacity it believes was created during the recession. The view here remains that the Bank is overplaying the excess capacity argument – the "output gap" is probably no greater than 2% of GDP – while core inflation will be underpinned by a continuing economic recovery, further upward pressure on import prices (barring a strong rebound in sterling) and an upward drift of inflationary expectations resulting from the current prolonged overshoot.

US equities, and "risk assets" generally, remain unusually sensitive to Federal Reserve liquidity operations – a relationship established after the Fed embarked on "QE1" in late 2008.

Stock markets began to fall in late April, 8-9 weeks after a peak in the US monetary base (i.e. currency in circulation plus banks' reserves at the Fed), while the rally starting in early July similarly followed a trough in the base 8-9 weeks before in early May – see chart.

After an initially strong recovery, however, the monetary base drifted lower again during June and July, creating a "negative divergence" with a further rally in stocks. Equities buckled last week, after the Fed disappointed hopes of an immediate move to "QE2", involving an expansion of its securities portfolio financed by further monetary base creation. (Instead, it plans to stabilise its portfolio by reinvesting maturing principal in Treasuries.)

With the monetary base moving sideways recently, equities may similiarly remain within the range spanned by the July low and last week's high until the next Fed meeting scheduled for 21 September.

Aside from embracing "QE2", the Fed could boost the monetary base by asking the Treasury to suspend the "supplementary financing programme" (SFP), under which it has effectively sterilised $200 billion of the Fed's "QE1" by issuing additional Treasury bills. The Fed used the SFP to drain liquidity this spring and may prefer this less-public method of providing support to markets and the economy, should "double-dip" worries intensify.