Based on yesterday's close of 11,985, the Dow Industrials index has fallen 3% from a peak on 18 February but is still 7% above the "six-bear average" path derived from recoveries after prior large declines – see first chart and previous post for more details.

The six-bear average has proved a reasonable guide to the trend in the Dow since the March 2009 trough. The average fluctuates between 11,100 and 11,600 until the autumn, when it slips below 11,000.

Examining the individual components, five of the six prior recoveries suggest a fall from the current level by year-end – see green lines in first chart. In one case, however, the Dow embarked on a final blow-off to a level equivalent to 16,000 currently – top line. (This refers to the rise from the bear market low in November 1903.)

As previously discussed, monetary trends are signalling a peak in global growth this spring. Momentum peaks are often associated with weakness in risk assets, including equities. G7 annual real narrow money growth, moreover, remains below industrial output expansion, a condition historically associated with sub-par equity returns. These considerations support the cautious message from the six-bear average, suggesting a defensive investment stance.

A short-term spurt higher, however, cannot be ruled out, based on the ongoing injection of liquidity by the US authorities. Banks' reserves at the Federal Reserve rose by a further $66 billion to $1.36 trillion in the week to Wednesday and are on course to reach $1.7 trillion, or more than 11% of GDP, by mid year, assuming that the Fed completes QE2 and the "supplementary financing program" is reduced to $5 billion and remains at this level. Bears, therefore, may wish to keep positions light until the Fed's liquidity boost is nearer completion.

Commentators often claim that interest rates must be kept low because fiscal tightening has yet to begin in earnest. This is misleading. Public sector net borrowing, adjusted for the economic cycle, is on course to fall by a whopping 1.8% of GDP between 2009-10 and 2010-11. If the economy is shown to be growing solidly in early 2011, the fiscal excuse for continued monetary laxity will look increasingly lame.

In its November update the Office for Budget Responsibility (OBR) projected that cyclically-adjusted net borrowing would fall from 8.8% of GDP in 2009-10 to 7.6% in 2010-11 and 5.3% in 2011-12. So fiscal restriction was forecast to amount to 1.2% of GDP this year, rising to 2.3% in 2011-12.

Recent headline numbers, however, have surprised favourably: the Institute for Fiscal Studies suggests that borrowing is on course to fall to £139 billion in 2010-11 versus the OBR's forecast of £148.5 billion and £156.4 billion in 2009-10. The £9.5 billion shortfall is equivalent to 0.6% of GDP and appears to reflect a structural improvement rather than stronger-than-expected economic growth (at least on current ONS GDP estimates).

Cyclically-adjusted net borrowing, therefore, may be about 7.0% of GDP in 2010-11 rather than the OBR's 7.6%, representing a 1.8 percentage point reduction from 2009-10. If so, the further decline needed to achieve the OBR's projection of 5.3% in 2011-12 would be 1.7 points. The government's borrowing goals, in other words, can be achieved without stepping up the pace of fiscal tightening between 2010-11 and 2011-12.


China's February trade deficit of $7.3 billion is further evidence that the economy is overheating and casts doubt on the wisdom and sustainability of RMB appreciation.

Analysts argue that the monthly figures are volatile and attribute the February deficit to the timing of the Lunar New Year holiday, expecting the balance to return to a substantial surplus. A deficit of $7.2 billion in March 2010 proved a one-off, with the surplus soaring to $28.7 billion by July.

Such claims, however, ignore a steady underlying deterioration in recent months. The chart compares the headline monthly balance with a three-month moving average of a seasonally-adjusted estimate. The latter was stable at about $12 billion at the time of the last monthly deficit in March 2010 but has fallen sharply recently, reaching zero in February.

This deterioration reflects a surge in import volumes and prices on the back of strong domestic demand.

China's inflationary boom is the product of loose domestic monetary conditions rather than an undervalued exchange rate. The correct response is to rein in monetary expansion and restore positive real interest rates rather than attempt to suppress inflation through Nixon-style price controls. The exchange rate may rise temporarily as part of this process but the normal pattern is for currencies of overheating economies to weaken as boom turns to bust.

Loose monetary policy has resulted in strong growth in nominal (i.e. current-price) spending over the last year but this has served to boost imports and inflation more than real domestic production. Higher interest rates would cool nominal spending expansion but could improve the split between real GDP growth and inflation / imports.

Doves argue that the MPC should maintain super-low rates because the economic recovery remains shaky. Monetary policy, however, operates by affecting nominal demand rather than real GDP directly.

"Gross final expenditure" – domestic consumption and investment spending plus exports – rose by a nominal 7.2% in the year to the fourth quarter of 2010 and would have increased by nearly 8% but for December's bad weather. This compares with average expansion of 5.5% per annum in the first 10 years of the MPC's existence (i.e. between 1998 and 2007).

One-quarter of gross expenditure, however, is on imports, which surged by 15.4% in the year to the fourth quarter. So nominal GDP – spending on domestically-produced goods and services – grew by a more modest 4.3%.

With inflation – as measured by the GDP deflator – running at an annual 2.8%, the increase in real GDP was reduced to just 1.5% (about 2% adjusted for the weather effect).

So imports and inflation ate up nearly 6 percentage points of the 7.2% growth in nominal spending in the year to the fourth quarter, resulting in a disappointing rise in real domestic production.

As noted by the MPC's Andrew Sentance, the recent gap between nominal spending and real GDP growth is the largest, except for two quarters in 2006 when trade numbers were distorted by missing trader VAT fraud, since the Lawson boom of the late 1980s – see chart.

Doves argue that the MPC should keep the pedal to the metal to ensure that real economic expansion is sustained. If inflationary expectations ratchet up, however, the pass-through from nominal spending to real production could weaken further. Tighter policy would slow nominal spending expansion but, by ensuring that the current inflation overshoot proves temporary, would improve prospects for a sustained economic recovery.

The ECB has signalled a likely rate rise in April but there is a much stronger case for monetary policy tightening in the US.

Real narrow money, M1, rose by 3% (not annualised) in the US in the six months to January versus a 1% contraction in Euroland – see first chart. M1 comprises currency and checkable / overnight deposits and is usually a better leading indicator of the economy than broader measures. The current divergence suggests that US growth will remain strong during 2011 while the Eurozone is about to slow sharply.

US M1 buoyancy cannot be attributed simply to QE2. Growth started to pick up last spring well before the Federal Reserve signalled another round of securities purchases. M1 does not include bank reserves at the Fed, which have risen 30% since QE2 started.

The US M1 pick-up has fed through to stronger economic expansion, an improving labour market and rising capacity pressures. Core inflation, meanwhile, is bottoming. A leading indicator of monetary policy based on changes in unemployment and core inflation and the ISM manufacturing supply bottlenecks measure has moved into the tightening zone for the first time since 2007 – second chart. (Caveat: the current Fed may behave differently.)

Central banks rarely commence policy tightening when narrow money is weak (whether or not they monitor it). The ECB's hawkishness recalls Bank of Japan rate rises in 2000 and 2006, which occurred against a backdrop of slowing (not contracting) real M1 and were subsequently reversed as the economy turned down. (In defence of the BoJ, economic weakness mainly reflected global rather than domestic developments.)

Note that M1 often slows after the first increase in interest rates, as money-holders switch out of demand deposits into higher-yielding time deposits and savings accounts. Such a portfolio shift may have limited implications for economic growth so M1 weakness may coexist with further rate rises (e.g. the US in the mid 2000s).