Construction output bounced back strongly in February after weather-related weakness in December and January but the sector is still likely to act as a significant drag on the first-quarter GDP estimate released later this month. There should, however, be a corresponding boost to the second quarter.

Construction accounts for 6% of GDP. Output is estimated to have risen by a seasonally-adjusted 8% in February from an upwardly-revised January level but was still 9% below the fourth-quarter average and 14% lower than in November, before the snow struck. It seems reasonable to assume that the November level will be regained in March or April – construction new orders rose by 18% between the third and fourth quarters and surveys suggest that weakness was temporary. Assuming a March return and stable output thereafter, construction would subtract 0.4 percentage points from GDP growth in the first quarter while adding 0.8 points in the second.

The rest of the economy may grow by about 0.75% in the first quarter, assuming modest further gains in services output in February and March and a reversal of the February decline in industrial production. The construction effect would then imply GDP growth of 0.3-0.4%. This shortfall would be offset in the second quarter. If non-construction output rose by a further 0.5%, GDP expansion would increase to 1.3%, based on the above assumptions.

The Monetary Policy Committee kept Bank rate unchanged at 0.5% despite evidence that the medium-term inflation outlook has deteriorated since the February Inflation Report.

That Report itself signalled a need for policy tightening, forecasting above-target inflation of 2.5% in two years' time if interest rates were held at 0.5%. The alternative projection based on market interest rate expectations was in line with the target but assumed that Bank rate would average 0.7% during the second quarter, implying a quarter-point increase in April or May.

Since February, actual inflation has again overshot the Bank's projection while commodity prices are now stronger and sterling weaker than assumed in the Report. The Bank's first-quarter inflation attitudes survey showed a rise in medium- as well as short-term inflationary expectations and wage settlements have moved up to an average 2.6% in the three months to February, versus 1.5% a year ago, according to Incomes Data Services.

Economic news has been mixed but not obviously softer than implied by the February forecast. First-quarter GDP could be held back by carry-over weakness in construction output following December's bad weather but construction orders and surveys suggest a strong rebound (February output is released tomorrow). Services activity has recovered solidly in early 2011 while private-sector labour demand continues to firm, judging from hiring intentions and online vacancies.

The news since February, therefore, argues for a further upward revision to the Bank's inflation forecast, which was already barely consistent with the target. The MPC's continued inaction is, at least to this author, baffling. The Bank, it seems, is prioritising supporting growth and assuming that this objective can be traded off against higher inflation. Such an approach is both misguided and in conflict with its inflation-targeting remit.

The Japanese stock market has underperformed the World index by 16% year-to-date, incorporating currency moves, according to MSCI – see first chart. Continental Europe has been the best performer closely followed by Canada, in both cases partly reflecting currency strength.

Unless they hedged, investors who rushed to add to Japan in the immediate aftermath of the earthquake have been hit by a sharp fall in the yen, following G7 "concerted" intervention (apparently involving minimal use of foreign official funds) and a large injection of liquidity by the Bank of Japan – second chart. Bank reserves at the central bank surged from ¥14.7 trillion on 10 March, the day before the earthquake, to ¥36.5 trillion on 25 March.

This liquidity boost, however, has taken the form of an increase in net lending to the banking system rather than Federal Reserve-style QE. The Bank of Japan has raised its asset purchase programme by only ¥5 trillion, with buying to be spread over more than a year, implying a monthly rate of about ¥400 billion or $5 billion – the Fed, by comparison, is expanding its securities portfolio by $15-20 billion per week.

The Bank may be reserving its ammunition but the statement issued after today's policy meeting does not suggest imminent radical action. The recent liquidity injection, therefore, is likely to reverse as conditions normalise and banks' emergency demand for funds falls back. This process may be under way, with bank reserves down by ¥3.9 trillion from their peak, and may lend support to the yen and, by extension, relative Japanese equity performance.

The "MPC-ometer" predicted an average interest rate vote of +14 basis points in March, up from +8 bp in February and just above the +12.5 bp threshold suggesting a rate increase – see previous post. In the event, the average vote was unchanged at +8 bp (counting Adam Posen's QE2 proposal as equivalent to a 25 bp rate cut).

The March minutes reveal that wavering members were concerned about economic weakness and unconvinced that inflationary expectations were becoming detached from the target. More recent news on these issues has been mostly hawkish.

Services and industrial output – accounting for 93% of GDP – rose strongly in January to stand 0.7% above the fourth-quarter level. The services recovery is more than a temporary bounceback, judging from upbeat business surveys – not just today's PMI but also the EU Commission business / consumer services survey released last week and yesterday's CBI financial services poll. GDP was held back in January by a further fall in construction output but this reflects carry-over from December's bad weather disruption and should be reversed.

On inflation, the Barclays survey reported a further rise in both short- and longer-term inflationary expectations in the first quarter, confirming the Bank of England's own poll (to which the MPC had early access at its March meeting). CPI and RPI figures again exceeded the consensus forecast in February, business survey pricing plans remain strong while pay settlements averaged 2.6% in the three months to February, up from 1.5% a year before, according to research firm Incomes Data Services.  

Policy shifts abroad could be a key factor tipping the MPC towards tightening. As of yesterday, sterling's effective rate had fallen by 1.9% from the starting level assumed in the February Inflation Report, partly as a result of the ECB signalling an interest rate increase despite seemingly lesser inflation difficulties than in the UK. Recent strong US economic news could result in the Federal Reserve also shifting tack, risking a further slide in the pound with attendant inflationary implications if the MPC continues to stand pat.

The MPC-ometer has moved further in a hawkish direction this month, predicting an average interest rate vote of +16 bp, consistent with six members favouring an increase (assuming that Andrew Sentance continues to vote for 50 bp while Adam Posen maintains his dovish dissent). It must be admitted, however, that MPC communications have not suggested an imminent change in the current stalemate while proximity to the Budget may incline some members towards further delay.

Household real disposable income fell by 0.8% in 2010 but real wealth gained an estimated 2% to stand only 6% below its 2007 high. A rising wealth to income ratio should maintain downward pressure on the saving ratio, supporting consumer spending.

Household net financial wealth – the market value of financial assets minus debt – grew by 10.1% between end-2009 and end-2010, according to National Statistics figures published last week. This reflected a capital gain on equities and corporate bonds held within life assurance and pension schemes, supplemented by additional saving.

Total wealth includes housing. Official 2010 figures on housing wealth have yet to be released but the Department of Communities and Local Government house price index – a key input – rose by 3.7% in the year to December. Assuming the same increase in the value of the housing stock, total wealth grew by 6% or a real 2%.

This 2% rise follows a 9% gain during 2009, implying that real wealth has retraced two-thirds of its 15% decline during 2008 – see first chart. The ratio of wealth to annual disposable income was an estimated 7.0 at the end of 2010, a level bettered in only two previous years (i.e. 2006 and 2007). The wealth to income ratio is inversely correlated with the saving ratio so the rebound supports expectations that a further fall in the latter will insulate consumer spending from income weakness this year – second chart.