US monetary trends continue to strengthen, supporting hopes of faster economic growth in the first half of 2011.

The monetary pick-up is evident in both narrow and broad measures – see first chart – and began in the summer before QE2 was under serious discussion. By injecting further liquidity, the Fed may again be acting in a destabilising fashion, in a mirror-image of its withdrawal of liquidity in early 2010 when money supply trends were worryingly weak.

The current contrast between real M1 strength in the US and a sharp slowdown in the Eurozone is unusual, last occurring in 1991 – second chart. US equities outperformed continental Europe by 17% in 1991 and 13% in 1992, partly reflecting a stronger dollar. As of the end of November, US stocks are 15% ahead of continental Europe this year (MSCI indices).

Higher global crude oil costs, a fall in sterling against the US dollar and coming hikes in VAT and fuel duty suggest that the average price of unleaded petrol will rise from £1.191 a litre in November to more than £1.25 in early 2011, well above the May peak of £1.215. The average diesel price is already above its spring high.

Based on the spot market price, adjusted for current VAT and fuel duty rates, the retail unleaded price looks on course to rise to about £1.23 – see chart. The VAT increase and fuel duty hike of 0.76 pence a litre from January will add a further 3.3 pence, suggesting a retail price of about £1.26 barring a spot market slide.

Such an increase would not provide a further boost to annual CPI inflation because petrol prices rose similarly steeply a year ago. Forecasters' previous assumption, however, that a slowdown in petrol inflation would partially offset upward pressures on the headline CPI rate is no valid. The view here remains that CPI inflation is likely to reach 4% or more early next year, a prospect endorsed by the MPC's Andrew Sentance in a recent article.

In further evidence that Chinese inflationary pressure is spreading from food to "core", output and input price balances in November's purchasing managers surveys (official and private) reached new highs in their 5-6 year histories. Current readings suggest that producer price inflation will accelerate from an annual 5.0% in October to more than 10% in early 2011 – see chart. Faster PPI rises, in turn, should lift CPI ex. food inflation from 1.6% towards 3% – see previous post for a chart of this relationship. (Official CPI numbers, of course, understate on-the-ground inflation.)

Chinese policy-makers aim to quell inflation by clamping down on credit and money growth via hikes in reserve requirements and lower lending quotas, avoiding a big rise in interest rates. The strategy is flawed because any slowdown in monetary expansion is likely to be offset by a pick-up in the velocity of circulation as real interest rates fall deeper into negative territory, encouraging more spending and financial speculation. By delaying a significant rate hike, the authorities risk having to slam on the brakes in early 2011, with adverse implications for the economy later next year. 

Eurozone real narrow money, M1, has stagnated over the last six months, suggesting that economic growth will slow sharply in early 2011 – see previous post.

M1 comprises currency in circulation and overnight deposits. The first chart shows the six-month change in real overnight deposits broken between the "core" and "periphery" (currency figures are not available by country).

The pace of contraction in the peripheral group eased in October but still signals economic stagnation, at best, in early 2011. The further fall in Eurozone-wide growth last month reflected a loss of momentum in the core, casting doubt on the ability of these economies to continue to decouple from peripheral weakness.

The second and third charts show a country breakdown. Real M1 deposits have contracted over the last six months in all five peripheral economies and also in Belgium and the Netherlands.

The ECB may have contributed to this weakness: its decision to withdraw 12- and six-month lending facilities has resulted in a 20% fall in the monetary base since June, in turn pushing up EONIA and increasing funding pressures on struggling banks. A reinjection of liquidity is urgently required but policy-makers are reluctant to reopen the lending window for fear of being swamped by demand from weaker sovereigns seeking back-door support via local banks.

The Office for Budget Responsibility under its new leadership today issued a 152-page report that makes rounding error changes to the economic and fiscal forecasts presented at the time of the June Budget. One of the few significant amendments is a downward revision to the loss of general government jobs over the next four years, from 490,000 to 330,000, although – like all the numbers in the report – this is "subject to a large degree of uncertainty".

The basic story is that a below-par but sustained economic recovery combined with the coalition's tax and spending plans will return the public finances to sustainability by 2015-16. Growth will be constrained, according to the OBR, by tight credit conditions, desired private sector debt reduction and the fiscal consolidation itself.

The OBR, like the consensus, is probably too downbeat about economic prospects. Forecast GDP growth of 2.4% per annum over the five years 2010-14 compares with 3.4% achieved over 1994-98 despite fiscal retrenchment on a similar scale. Claims that the private sector is in a weaker position to take up the baton than in the early 1990s are unconvincing: corporate finances are in better shape and households have been insulated from the consequences of higher debt by low interest rates, resulting in fewer arrears cases and repossessions. There were similar concerns about credit supply in the 1990s, following a large hit to banks' capital from residential and commercial property busts.

Rather than a growth shortfall, the key risks to the fiscal outlook are that, first, the coalition fails to implement planned spending cuts and / or tax increases yield less revenue than expected and, secondly, higher interest rates boost debt servicing costs. A useful ready-reckoner table on page 117 of the report shows that each 1 percentage point rise in interest rates and inflation raises debt interest spending in 2015-16 by £10.7 billion, or 0.6% of GDP.

The net percentage of UK consumers expecting prices to rise at a faster pace over the next year is at its highest level since July 2008, according to the November EU Commission consumer survey – see chart.

The net percentage reporting an increase in prices over the last 12 months also rose further and is well above its long-run average.

The forward-looking indicator usually leads swings in inflation and the latest rise is consistent with the forecast here of a pick-up in the headline CPI rate to 4% or more in early 2011, a prospect also mooted by MPC member Andrew Sentance in an article yesterday.