Bond yields fluctuate with economic momentum. Korea’s export dependence makes its economy especially sensitive to shifts in the global cycle. Its bond yields, therefore, often lead movements in US Treasuries.

For example, Korean 10-year yields plunged by 60 basis points between February and March, bucking a rising trend in the US. This proved a timely warning of an April peak and subsequent big decline in Treasury yields – see chart.

The two markets are now diverging again, with 10-year Korean yields up by 60 basis points over the last three weeks versus little change in the US. If the Korean rise reflects stronger global / US economic momentum, Treasury yields should follow, notwithstanding Fed buying.

World equities have broadly tracked the G7 monetary base (i.e. currency in circulation plus bank reserves) since the Federal Reserve launched QE1 in late 2008. A wide gap, however, has opened up recently as markets have anticipated a further US liquidity injection – see first chart.

The Fed has now launched QE2 by signalling an intention to buy a net $600 billion of securities by mid 2011. The chart shows a projection for the G7 monetary base assuming that 1) it purchases the full amount on schedule, 2) there is no sterilisation of the impact on US bank reserves and 3) the base is static in other G7 countries.

Based on the relationship to date, the projected level of the G7 monetary base in mid 2011 suggests a further 6% rise in equity markets in US dollar terms. Bulls, however, may wish to consider the following qualifications.

First, equities are currently at a level consistent with the projected G7 base in April 2011, i.e. markets may be five months "ahead of the game".

Secondly, the Fed could scale back its intended purchases if economic growth accelerates in early 2011. Such a scenario is suggested by a recent strong pick-up in US real narrow money, M1, which leads activity by about six months – second chart. (QE2 is, at best, unnecessary. There was a stronger case for action last spring, when money growth was weak; instead, the Fed allowed the monetary base to contract, contributing to recent sluggishness.)

Thirdly, even if it buys the full $600 billion, the Fed may choose to sterilise part of the impact on the monetary base, for example by offering banks term deposits or expanding the “supplementary financing programme”, under which the Treasury issues additional bills to soak up liquidity (used during QE1).

Finally, US monetary base expansion may be offset by contraction elsewhere. The Eurozone base, already down by 20% from a summer peak, may continue to decline as the European Central Bank restores pre-crisis liquidity provision arrangements. Further rises in reserve requirements and official rates, meanwhile, are likely in China, where inflation has been driven higher by surging commodity prices caused in part by the Fed’s expansionary policies.



Recent news supports the earlier forecast of a rise in CPI inflation to about 4% by early 2011, from 3.1% in September. October figures, released on 16 November, may increase to 3.3-3.4%.

• BRC shop price inflation moved up by 0.4 percentage points between September and October. The BRC survey covers non-energy goods, which constitute about 46% of the CPI. Impact on headline CPI rate: +0.2 percentage points between September and October.

• Higher petrol / diesel prices in October versus little change a year before should push motor fuel inflation up from 9.3% in September to about 12%. Impact: +0.1 percentage points in October.

• Commodity price pass-through should result in CPI food inflation rising to at least 7% versus 4.9% in September. Impact: further +0.2 percentage points by early 2011.

• Bank of England survey evidence points to much higher pass-through of the coming VAT hike to 20% than for this year's return to 17.5%. Impact: up to +0.6 percentage points by early 2011.

• The rise in gas tariffs announced by Scottish and Southern, if followed by other suppliers, will push the CPI gas change up from an annual -5.7% to 3% by January and 9% by April. Impact: +0.4 percentage points by April 2011.

The CPI profile shown in the chart below superimposes these factors on a stable underlying inflation rate of 2.25-2.5%. It suggests an average CPI rise of 3.9% in 2011, with inflation at or above the 3.1% letter-writing level throughout the year.

Eurozone monetary statistics for September were disappointing, showing a further slowdown in six-month growth of real M1, in contrast to a pick-up in the US. Eurozone economic news has surprised positively relative to the US recently but the pattern may reverse over coming months, lending support to the US dollar.

Within Euroland, real M1 deposits continue to grow solidly in "core" economies while now contracting in the periphery (i.e. Greece, Ireland, Italy, Portugal and Spain), with the rate of decline ominously similar to early 2008 – see first chart. Stagnation or renewed recession would derail fiscal consolidation plans and could force several countries to access the untested European Financial Stability Facility. Sovereign spreads may be starting to sniff this scenario, with euro weakness to follow.

Peripheral monetary contraction is not confined to the smaller economies: after Greece, real M1 deposits have declined most in Spain over the last six months and are also now falling in Italy – second chart.

Chinese business surveys for October confirm earlier signs of a pick-up in economic growth accompanied by rising inflationary pressures.

The purchasing managers' input price index rose to a record high in data extending back to 2005, signalling a reacceleration of producer price inflation – see first chart.

An earlier post suggested that annual consumer food price inflation would rise to more than 10% by October, pushing the headline CPI rate towards 4.5%. This forecast remains on track: food inflation moved up to 8.0% in September and agricultural product prices continued to surge into early October – second chart. (Interestingly, the product price series has stopped updating on Datastream because it has been "suspended by the source".)

The decision to slow tightening efforts this summer appears to have been a major mistake, leaving policy-makers far behind the curve. Global markets are vulnerable to a catch-up, which may offset any positive impact from the Fed's QE.

In a recent speech, Mervyn King, Governor of the Bank of England, claimed there was a shortage of money in the British economy. This shortage, he argued, was a drag on economic growth and threatened to push inflation below the 2% target over the medium term, a prospect warranting consideration of a further round of “quantitative easing” (QE).
 
Mr King’s diagnosis is faulty. Far from a shortage, there may be surplus money circulating in the economy at present. This means a further injection of liquidity by the Bank’s Monetary Policy Committee (MPC) could boost prices rather than economic activity, sustaining the current inflation overshoot.
 
The Governor’s claim stems from recent slow growth in the broad money supply – the stock of savings held by consumers and companies in the form of notes and coin and bank and building society deposits. Broad money has risen by only 2% over the last 12 months, compared with an average annual growth rate of 7% over the previous decade.
 
Any judgement about money supply adequacy, however, must also take into account the velocity of circulation – the rate at which the existing money stock turns over. A rise in velocity has exactly the same economic impact as an expansion of the money supply itself. Velocity has surged over the last year and there are grounds for believing this pick-up will continue. This means monetary conditions are much looser than Mr King and his fellow MPC doves claim.
 
Velocity is calculated by dividing gross domestic product (GDP), measured at current prices, by the money supply. The recent increase is unusual: over the last 50 years, broad money velocity has fallen by 0.5% a year on average.
 
To support real economic growth of 2.5% a year along with inflation in line with the 2% target, money supply expansion and the change in velocity must add up to 4.5%. If velocity were to decline at its historical 0.5% rate, broad money would need to expand by 5% a year rather than the current 2%. This explains why many economists are calling for a further infusion of liquidity.
 
The trend in velocity, however, is not fixed but depends on the relative attraction of money as a store of savings. When deposit-account interest rates fall below inflation, as at present, families and firms have a strong incentive to economise on money holdings, resulting in an increase in the rate at which the existing stock turns over.
 
One way of getting rid of excess liquidity is to spend it – this provides a direct boost to the economy and prices. Savers will also attempt to move money into other assets offering either higher yields or greater perceived protection from inflation. Resulting increases in asset prices lift wealth and confidence, thereby supplying an additional indirect stimulus to economic activity.
 
Recent news fits this story. Economic growth and, especially, inflation are running well ahead of Bank of England and consensus forecasts. Current-price GDP has risen by a bumper 6% over the last year. With broad money up by only 2%, velocity has climbed 4% – the largest annual gain since 1980.
 
Further evidence of a “dash from cash” includes record retail buying of mutual funds and a decline in institutional investors’ “liquidity ratio” – the proportion of their portfolios held in money and short-term securities.
 
Meanwhile, equities, bonds, housing, commercial property, commodities, art, antiques and fine wine have all appreciated, in some cases substantially, over the last year – strongly suggestive of surplus money rather than the Governor’s mooted shortage.
 
The recent pick-up in velocity contrasts with a slump during the financial crisis as investors scrambled to reduce exposure to markets. This decline, coupled with a slowdown in money supply growth, imposed a vicious monetary squeeze on the economy, explaining the recession’s severity and justifying the first round of QE launched in March 2009.
 
Those arguing favour of further monetary stimulus now implicitly assume that the velocity rise will slow sharply or reverse. The shift in financial behaviour, however, may be at an early stage, with many families and companies yet to take on board the MPC’s message – reinforced by the Bank’s Deputy Governor, Charles Bean, in a recent interview – that monetary savers should expect to suffer a sustained erosion of their real wealth.
 
In the 1970s, when interest rates were last held beneath inflation for a sustained period, broad money velocity rose by 39% over six years, or almost 6% a year. If such an increase were repeated now, the current 2% rate of broad money expansion would deliver a large inflation overshoot.
 
More QE, therefore, would be dangerous. Money supply trends may be starting to improve, with annual growth up from 1% in the summer. A further QE injection could have more powerful effects than last year, when additional liquidity was partly absorbed by capital-raising by banks. It could increase surplus money in the economy, resulting in higher inflation and new asset price bubbles.
 
Rather than further stimulus, the Governor and his colleagues should be discussing restoring positive real interest rates to reflect the normalisation of economic and monetary conditions. An increase would help rebuild the MPC’s tattered inflation-fighting credibility as well as promoting necessary economic balancing. The Governor should take away the punch bowl instead of threatening to spike the cocktail and turn up the party music.

An edited version of this article appeared in today's Daily Telegraph.