This week's Federal Reserve policy statement raised market expectations of "QE2" asset purchases but, perversely, the Fed has allowed the monetary base – currency in circulation plus banks' reserve balances – to contract recently. The base fell by 2.7% in the week to Wednesday to stand at its lowest level since January and 10.1% below the February peak – see chart.

The decline in the latest week reflected a rise in the Treasury's general account balance at the Fed, which resulted in an equivalent outflow from banks' reserves. The general account balance fluctuates as receipts from taxes and debt sales vary in relation to Treasury outlays but the Fed, in theory, can offset the impact on reserves, for example by offering banks repo loans or increasing securities purchases.

If the Fed wished to boost the monetary base ahead of any QE2 decision, it could ask the Treasury to reduce the $200 billion balance in its "supplementary financing account". An increase in this balance was used to drain cash from banks' reserves this spring, when the Fed was mulling an "exit strategy" – discussed in a post at the time.

The fall in the base may prove temporary but the Fed's failure to offer resistance suggests that the internal debate has yet to be resolved in favour of further easing.

As originally discussed in a post last year and illustrated by the chart, fluctuations in the monetary base have tended to lead stock market movements since the Fed embarked on "QE1" in late 2008.

"QE2" is the wrong response to recent economic softening and, if implemented, is likely to prove counterproductive.

Some QE2 proponents claim that G7 economies are suffering from a shortage of liquidity, evidenced by slow expansion in the broad money supply. (The UK's preferred broad money measure rose by only 1.2% in the year to July, though growth has been faster over the last six months.) An assessment of monetary adequacy, however, must take account of demand as well as supply. Money demand has been depressed by negative real interest rates, which have encouraged a large-scale portfolio shift out of deposits into other assets offering a higher yield and / or inflation protection. Record mutual fund inflows are one reflection of this adjustment.

Put differently, slow money supply expansion is being offset by a rise in the velocity of circulation. Broad money velocity rose by 4.4% in the UK in the year to the second quarter, allowing nominal GDP to expand by 5.9%. When real interest rates were last negative for a sustained period in the 1970s, velocity rose by a cumulative 38.6% over six years, or 5.6% annualised. A similar rate of increase is plausible now, suggesting that broad money expansion of 1-2% per annum is more than sufficient to finance trend economic growth of about 2.5% with 2% inflation.

Rather than inadequate monetary growth, the Federal Reserve this week cited dangerously-low inflation as a reason for considering QE2. The rise of just 0.9% in the consumer price index excluding food and energy over the last year, however, is heavily influenced by a 0.3% fall in "owners' equivalent rent" – a theoretical sum paid by home-owners to themselves. An alternative CPI measure based on the EU's harmonised methodology, which omits imputed rent, rose by 2.1% in the year to July, according to a comparison table produced by the Bureau of Labor Statistics.

There has been no sudden deterioration in inflation news to warrant the Fed's heightened concern. The CPI excluding food and energy increased by an annualised 1.3% in the three months to August, above the 0.9% annual gain. The September University of Michigan consumer survey reported a mean expectation for inflation over the next five years of 3.2%, equal to the average of the last two years.

Some economists support more QE not because they think it is strictly necessary but as an "insurance policy". This wrongly assumes that it would be costless. Additional liquidity, however, might flow into already-overheated financial markets, risking the formation of new bubbles and subsequent disruptive busts.

QE2, indeed, is probably already harming economic prospects by encouraging further speculative buying of food commodities. Recent commodity price gains suggest that G7 CPI food inflation will rise from an annual 0.9% in July to 4-5% – see chart. This would add 0.3-0.4 percentage points to headline CPI inflation, with an equivalent negative impact on consumer purchasing power. As discussed yesterday, the effects will be more serious in emerging economies.

Recoveries proceed in fits and starts and policy-makers should be cautious about attempts at "fine-tuning", which may simply increase volatility. To the extent that policy is constraining economic expansion, proposed tax increases and their impact on confidence are of greater concern than insufficiently loose monetary conditions. In the UK, this argues for postponing or cancelling the planned VAT hike, which will pile more pressure on struggling consumers and may no longer be required given recent deficit improvement – see previous post.

Rising food prices may crimp UK consumer spending later this year but food inflation is a much bigger issue in emerging economies – the average weight of food in the CPI baskets of 120 non-OECD countries was 37% in 2006, according to a 2008 IMF study, versus 10% in the UK currently. (Food is much more important for consumers in these economies than fuel, with a 7% average weight in 2006.)

Chinese CPI food inflation rose to an annual 7.5% in August and may reach 9% by October, judging from data on edible agricultural product prices – see chart. (Product prices suggest a further increase of 1% or more in the CPI food index, which was little changed between August and October last year.) With food accounting for one-third of the CPI basket, this could push headline CPI inflation up from 3.5% currently to about 4%.

US stocks have rallied recently despite equity analysts making more downgrades to 12-month-forward company earnings estimates than upgrades. The "revisions ratio" (i.e. the difference between the numbers of upgrades and downgrades in a particular period, divided by the total number of earnings estimates) correlates with business surveys; current weakness suggests that the ISM manufacturing new orders index will fall further to around the break-even 50 level, while remaining above the 45 threshold consistent with a "double dip" – see chart.

Public sector net borrowing exceeded expectations in August but this was roughly balanced by downward revisions to earlier months in 2010-11, reflecting lower central government current expenditure and a higher yield from the bank payroll tax (now estimated at £3.5 billion versus £2.5 billion in the June Budget). Borrowing remains on course to undershoot the OBR's full-year forecast of £149 billion by a significant margin.

Attempting to adjust for seasonal factors, borrowing excluding the temporary impact of financial interventions averaged £11.65 billion in the first five months of the fiscal year, or £140 billion annualised – see chart. The OBR forecast, therefore, implies renewed deterioration over the remainder of 2010-11.

This is unlikely because the benefits of economic recovery should grow as the year progresses while much of the £8.1 billion of spending cuts and tax rises announced since the election has yet to take effect. Even assuming no further decline in the underlying run rate, these measures should lower full-year borrowing to £136 billion or less.

The evolving undershoot increases doubts about the wisdom of the coming VAT hike (projected to raise £12.1 billion 2011-12), especially with consumers facing a large rise in food bills this winter – food commodity prices have continued to climb recently, with the CRB spot foodstuffs index in sterling terms now 11% above its August average.

Following its recent rally, the Dow Industrials index stands only 2% below the "six-bear average" path discussed in previous posts, based on recoveries after previous large US stock market declines – see chart.

A post in May speculated that tighter global liquidity would push the Dow, then trading in line with the average, into the lower half of the six-bear range, thereby presenting a buying opportunity. At the trough in early July, the index was 10% below the six-bear mean and only 1% above the bottom of the historical range.

Liquidity indicators have improved at the margin but have yet to turn positive, suggesting that the Dow will struggle to move above the six-bear average. G7 real M1 expansion is still well below industrial output growth in year-over-year terms but is close to converging on a six-month basis. The G7 monetary base has been moving sideways after falls in the spring and summer, with an increase possible if the Federal Reserve embarks on "QE2" and / or the Japanese authorities conduct further unsterilised currency intervention.

The six-bear average moves gradually higher over the remainder of 2010, finishing the year 6% above the Dow's closing level on Friday.