Eurozone monetary trends continue to weaken, signalling an economic slowdown this spring and summer and casting doubt on the wisdom of the coming official interest rate hike.

The headlines look favourable, with the broader M3 money supply measure rising by 0.5% in February, pushing annual growth up from 1.5% to 2.0%. The trend, however, has deteriorated in recent months, with six-month expansion falling from a peak of 3.5% annualised in August to 1.1% in January and just 0.6% in February.

Narrow money M1, moreover, contracted in the six months to February, by an annualised 0.8% – the first six-month decline since August 2008, when the economy was in freefall.

Recent trends, of course, look much worse in real terms, with consumer price inflation boosted by energy and food price increases.

Real M1 is a good leading indicator of economic activity. It contracted from late 2007 ahead of the onset of the recession in spring 2008 and surged in late 2008 before a GDP recovery from mid-2009 – see first chart. Real M3 has been much less reliable, although the two measures are currently giving an identical message.

M1 comprises currency in circulation and overnight deposits. The ECB provides a geographical decomposition of overnight deposits but not currency. As the second chart shows, real deposit weakness was initially focused on peripheral economies – defined here as Greece, Ireland, Italy, Portugal and Spain – but has now spread to the core. The fall in business expectations in today's Ifo survey for March probably marks the start of a sustained decline.

The Chancellor set out ambitious goals of creating the most competitive tax system in the G20 and making the UK the best place in Europe for business but his ability to deliver on these aims was undercut by a negative reappraisal of the state of the public finances by the Office for Budget Responsibility. Despite an undershoot in 2010-11, the OBR raised its deficit projections for subsequent fiscal years, with the 2015-16 shortfall increasing from 1.0% to 1.5% of GDP, reflecting both lower economic growth and a worse structural position.

Mr Osborne, therefore, was forced to find further savings to finance his priorities: the net cost of the measures announced is just £10 million in 2011-12 and a cumulative £30 million by 2015-16. He managed, nonetheless, to spring some favourable surprises, including a 1 pence per litre cut in fuel duty (costing £1.9 billion in 2011-12), a faster reduction in corporation tax (£425 million in 2011-12 rising to £1.075 billion in 2015-16), reform of the controlled foreign company rules (£840 million by 2015-16) and a further £630 rise in the personal allowance from next year (£1.05 billion in 2012-13). These giveaways were financed by a higher supplementary charge on North Sea oil profits (raising £1.78 billion in 2011-12), another attack on avoidance and evasion (£985 million in 2011-12), switching to CPI indexation of direct taxes from next year (£105 million in 2012-13 rising to £1.08 billion in 2015-16), a reduction in national insurance contracted-out rebates (£640 million in 2012-13) and the introduction of a carbon price floor from 2013-14 (£1.41 billion in 2015-16).

While there is an element of "robbing Peter to pay Peter", the impression is that the Chancellor has played a poor hand skilfully, and the Budget may earn political plaudits. Its short-term macroeconomic impact, however, will be negligible.

The OBR's negative reassessment of fiscal prospects is a direct consequence of the Bank of England's failure to control inflation: the upward revision to the deficit forecasts is due to higher spending that, in turn, "primarly reflects the impact of our higher inflation forecast on social security and debt interest payments". Debt interest is now projected to rise from £43.1 billion in 2010-11 to £66.8 billion in 2015-16, £3.7 billion higher than in November and equivalent to 3.5% of GDP.

Financing plans show net gilt sales of £120.0 billion in 2011-12, only £7.8 billion lower than in 2010-11 despite a projected fall in public sector net borrowing from £145.9 billion to £122 billion. Gilt funding needs have been boosted by the surprise announcement of a £6 billion increase in the foreign exchange reserves. The sum is small but the policy change is interesting, suggesting a desire for greater protection in the event of future sterling weakness.

CPI inflation rose from 4.0% in January to 4.4% in February, above the consensus forecast of 4.2% but in line with the projection made in a post a month ago. The chart presents an updated profile for 2011 and 2012, based on the same assumptions as in the prior post. Inflation is forecast to fluctuate in a 4.2-4.5% range over the summer and autumn before subsiding from late 2011 as base effects turn favourable. It remains well above the 2% target in 2012, however, averaging 2.5%.

Risks to this forecast are judged to lie on the upside. In particular, the assumption that core prices (i.e. excluding energy and unprocessed food) increase at a 2.25-2.5% annualised pace may prove too low, based on recent evidence that inflation expectations are becoming detached from the target. Further increases in energy and food prices, of course, are also possible.

With February's 4.4% outturn projected to be repeated in March, inflation is on course to average 4.2-4.3% in the first quarter – above the Bank of England's forecast of 4.1% in the February Inflation Report.

Doves claim that inflation would be below target but for indirect tax rises and higher food and energy costs. The Office for National Statistics estimates that full pass-through (unlikely) of tax increases would have boosted the CPI by 1.7 percentage points over the last year. Above-average rises in food and energy prices arithmetically account for a further 1.1 percentage points of current inflation.

Subtracting these effects from the 4.4% headline rate to argue that "true" inflation is below 2%, however, is intellectually flawed. Had taxes remained stable and food and energy prices risen more modestly, consumers would have had more cash to spend on other goods and services, the prices of which would have increased correspondingly faster.

The fundamental cause of above-target inflation has been strong growth in nominal demand, in turn reflecting excessively loose monetary conditions. "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).

Recent evidence confirms that the prolonged inflation overshoot is feeding through to longer-term expectations and pay settlements. The median level of settlements in manufacturing and private services was 2.9% in the three months to January, according to Incomes Data Services, a level that, if sustained, suggests a pick-up in private-sector regular earnings growth from an annual 2.1% in January to 3.6% by the end of 2011 – see previous post. Faster labour cost expansion could push core inflation higher in late 2011 and 2012 even as imported inflationary pressures ease.

The Bank of England has identified a rise in inflation expectations as a key risk in each of the last three Inflation Reports. The Bank's latest inflation attitudes survey suggests that, at least among UK households, this risk is crystallizing, with two- and five-year expectations moving significantly higher in addition to the more volatile year-ahead measure – see first chart.

Interest rate doves, therefore, have shifted tack, arguing that rising expectations matter only to the extent that they influence wage- and price-setting. In a recent speech, the MPC's Adam Posen claimed that "observed recent movements in short-term household inflation expectations will not affect wage bargaining, and so will not push up inflation outcomes". Dr Posen expects pay growth to remain stable in 2011 and 2012.

Private-sector regular earnings (i.e. excluding bonuses) rose by 2.1% in the year to January. This increase, however, reflected an average wage settlement of only 1.7% during 2010. According to pay research firm Incomes Data Services, the median settlement level moved up to 2.9% in both manufacturing and private services in the three months to January. If sustained, this implies a significant rise in earnings growth during the course of 2011.

The second chart compares annual growth in regular earnings with a 12-month moving average of settlements. The difference is "pay drift" – the additional boost to earnings from pay progression, interim adjustments and restructuring outside the annual review. (Pay drift also reflects changes in average weekly hours, which fell during the recession but recovered in 2010.)

If the median settlement level remains at 2.9%, and pay drift returns to its 2005-07 average of 0.7 percentage points, annual growth in private-sector regular earnings will rise to 3.6% by the end of 2011. If, in addition, bonuses pick up in response to stronger productivity and corporate profits, total pay expansion could reach 4% – too high for achievement of the 2% inflation target over the medium term. (Private-sector productivity is unlikely to grow by more than 2% per annum on average while unit labour costs probably need to rise by less than 2% pa to meet the target, allowing for imported inflationary pressures.)