US bank reserves at the Federal Reserve rose by a further $72 billion in the week to Wednesday, to $1.22 trillion – just below the peak of $1.23 trillion reached in February 2010 and equivalent to 8.2% of annual GDP. The increase reflected the Fed's continued QE2 securities purchases and a flow of cash out of the Treasury's accounts at the central bank, partly due to the rundown of the supplementary financing program* (SFP).

As previously discussed, if the Fed completes QE2 and the SFP falls to $5 billion and remains at this level, bank reserves will reach about $1.68 trillion by mid 2011, barring any offsetting sterilisation actions. This would represent a 69% increase since QE2 started in early November. Reserves would equate to 11.1% of GDP compared with less than 0.1% before the financial crisis – see first chart.

Such a reserves to GDP ratio would be unprecedented in the Fed's 98-year history. The previous high, of 6.9%, was reached in 1940 as the Fed flooded the system with liquidity after the 1937 Roosevelt recession. On that occasion, the increase in reserves was followed two years later by a surge in CPI inflation into double-digits – second chart.

The prospective reserves to GDP ratio is double the level reached in Japan during its QE experiment in the early 2000s – the ratio peaked at 5.6% in 2004.

The rise in Japanese reserves did not lead to inflation because there was little impact on monetary trends. Growth in the M1 and M2 measures was stable at annual rates of 4-5% and 1-2% respectively in 2004-05.

In the US in the late 1930s, by contrast, M1 and M2 growth started to accelerate soon after the Fed began to inject liquidity in 1937 and reached double-digits in 1939-40.

Fed Chairman Ben Bernanke claims that the current reserves surge will not result in higher inflation. With policy in uncharted territory, he cannot possibly know. Monetary trends are beginning to resemble the US in the late 1930s rather than Japan in the 2000s: M1 and M2 growth have risen from annual rates of 4% and 2% respectively in July last year to 10% and 4% in January. Further M2 acceleration would ring inflationary alarm bells.

*The SFP was instituted as a crisis measure in late 2008 and involved the Treasury issuing additional bills and depositing the proceeds at the Fed for onlending to distressed financial institutions. It reached a peak of $559 billion in November 2008 and was stable at $200 billion between April 2010 and January 2011. In late January, however, the Treasury announced its intention of reducing the SFP to $5 billion in order to slow the rate of increase of the federal debt, which is approaching the legislated ceiling. As of Wednesday, it had fallen to $150 billion. The Fed repays the Treasury by creating new bank reserves.

In his most hawkish speech to date, the MPC's Andrew Sentance dissociates himself from the medium-term inflation forecast in the February Inflation Report (which itself seems to call for an early rate rise – see previous post) while arguing that the Committee's failure to tighten policy earlier will mean bigger and sharper interest rate rises, with attendant risks to recovery prospects. The speech suggests that Dr Sentance voted for a half-point Bank rate hike at last week's meeting.

The previously-discussed "MPC-ometer" model, meanwhile, is currently signalling a 70% probability of a quarter-point increase in March but could change significantly depending on the February MPC vote, fourth-quarter GDP revision and consumer / purchasing managers survey results for February. A contributor to the hawkish reading is a further increase in the net percentage of CBI industrial firms planning to raise prices in February (released today), suggesting that CPI goods inflation will rise from 3.8% in January to about 5% – see chart.

The forecasts in the latest Inflation Report are hard to square with the MPC's decision to leave Bank rate unchanged at its February meeting. This suggests that either rates will rise very soon or the Committee's commitment to achieving the 2% target over the medium term has weakened.

Bank of England Governor Mervyn King's interpretation of the MPC's remit is that policy should be set to achieve 2% inflation over the medium term, taking into account any skew of risks. A summary measure of whether the Committee is on track to deliver this objective is the mean two-year-ahead forecast based on unchanged interest rates and asset purchases. (The mean forecast, unlike the central projection, incorporates the risk skew.)

Chart 5.13 of the Report shows that, on this unchanged policy assumption, the Committee's central expectation is for inflation of 2.1-2.2% in two years' time but risks are judged to be skewed significantly to the upside. The mean forecast, therefore, is about 2.5% (estimated from the chart – the underlying numbers are released with a week's delay). The implied 0.5% overshoot of the target is the highest in any Inflation Report since 1997-98, when official rates rose by more than 150 basis points over 14 months – see chart.

Further information is provided by the alternative forecast in chart 5.1 based on market interest rate expectations, implying quarter-point rises roughly every three months starting in May. Even on this basis, the mean two-year-ahead forecast appears to be above 2%, taking into account the upward risk skew. The Inflation Report, therefore, is signalling a need for even faster tightening than the market now discounts.

The out-of-consensus view here has been that the MPC would use the February Inflation Report to signal a strong tightening bias, following through with a hike in March, barring data shocks. The new projections are consistent with this forecast but the balanced rhetoric of Governor King at the press conference is not. The February minutes will reveal more but, for now, the suspicion is that the Committee is split down the middle, with the Governor struggling to keep the hawks at bay.

Despite some downbeat headlines, there are glimmers of hope in the latest labour market numbers.

The number of employees rose in three months to December from the overlapping September-November period. This follows a recovery in vacancies, which increased further in the three months to January – see first chart. The vacancies rise accords with surveys of labour demand, such as the Monster index discussed in a prior post, although National Statistics attributes much of the recent pick-up to temporary hiring associated with the 2011 Census.

Also encouraging was a shift from part- to full-time employment, resulting in a rise in average weekly hours. With employee numbers increasing, aggregate hours worked in the latest three months were the highest since November 2008-January 2009.

Claimant-count unemployment edged higher in January but the three-month moving average has fallen since the autumn, suggesting that the recent increase in the Labour Force Survey measure will prove temporary – second chart.

The UK's high inflation rate is not simply the result of "one-off" factors but reflects an overly-loose monetary policy stance that has resulted in rapid growth in nominal spending. An early rise in interest rates is necessary to prevent the overshoot being built into inflationary expectations, which would make an eventual return to target more painful to achieve.

This article is continued on the Financial Times website.

The rise in CPI inflation to 3.7% in December and 4.0% in January was in line with a suggested profile prepared after release of the November number, although there were small differences in the detail. The chart shows an updated forecast based on the following assumptions:

• Unprocessed food inflation rises further to a peak of 7% in March before moderating to 3.5% by year-end.

• Energy prices trend gradually higher, with a 2.5% rise over the next 12 months.

• "Core" inflation – excluding energy and unprocessed food – runs at 2.25-2.5% annualised, in line with an estimate of the trend leading into the recent VAT hike.

On this basis, the headline CPI rate is projected to reach 4.4% in February, returning to this level in September before subsiding to 2.5% in early 2012 as the VAT effect drops out.

The core assumption underlying this forecast is conservative: rising inflation expectations and eroding spare capacity could lead to a firmer core trend moving into 2012.

In his latest explanatory letter, Bank of England Governor Mervyn King states that "The MPC's central judgement, under the assumption that Bank Rate increases in line with market expectations, remains that, as the temporary effects of the factors listed above wane, inflation will fall back so that it is about as likely to be above the target as below it two to three years ahead."

Despite the "remains", this appears to represent a hawkish shift relative to the November Inflation Report, which judged that inflation was more likely to be below 2% (probability of 56%) at the two-year horizon on the basis of less aggressive market expectations than currently. If confirmed tomorrow, the implication is that the MPC is endorsing the market's view of three quarter-point rate hikes during the course of 2011.