G7 consumer price inflation rose to 2.0% in February, according to the OECD, and is likely to have reached 2.3% in March, based on available national data – see first chart. Importantly, "core" inflation (i.e. excluding food and energy) has also picked up recently, from 0.65% in October to 1.0% in February with a further gain indicated for March.

The monetarist rule is that money supply changes lead the real economy by between six months and a year and inflation by about two years. The second chart shows G7 CPI inflation with a smoothed measure of narrow money supply growth (a 23-month centred moving average). The money measure fell steeply from late 2005 reaching a low in September 2007. Inflation spiked in 2007 and 2008 as commodity prices surged but then slumped in the wake of the recession. Headline prices fell in 2009, with the annual decline reaching a maximum in July 2009, 22 months after the trough in money supply growth, i.e. consistent with the monetarist rule.

Monetary expansion recovered strongly from late 2008 in response to central bank easing, with the smoothed measure reaching a peak in October 2009. The monetarist rule, therefore, suggests that inflation will continue to trend higher into autumn 2011.

A subsequent decline, however, may be modest and temporary. The chart includes an extrapolation of the smoothed measure assuming that annual growth in narrow money remains at its February level of 7.2%. The extrapolation subsides to a minor low in November 2010 before resuming an upward trend. The message is that inflation may trend lower between late 2011 and late 2012 but is likely to remain high by recent standards, with renewed upward pressure possible in 2013.

The suggestion in a previous post that the housing market would remain resilient in early 2011 is supported by the National Association of Estate Agents' March survey, showing the average number of house-hunters registered per branch rising to an eight-month high. This builds on a solid February gain and may presage a recovery in mortgage approvals for house purchase – see first chart.

House-hunting is an early barometer of consumer spirits; the NAEA measure turned down from late 2009 ahead of a decline in the EU Commission consumer confidence indicator – second chart. The February / March pick-up suggests that an improving labour market is starting to outweigh high inflation and fiscal tightening and could herald a recovery in confidence. The stock market may be sniffing this scenario, judging from recent better performance of retail shares.

Economists project US annual average inflation of 2.3% over the next 10 years, according to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. Assuming that this is representative of wider market expectations, the current 10-year Treasury yield of 3.4% implies a real interest rate of only 1.1%.

The first chart shows a long-term history of this real yield measure (i.e. the 10-year Treasury rate minus economists' 10-year inflation forecast)*. The current 1.1% compares with a median real yield since 1953 of 2.6%. This suggests that the nominal 10-year yield would need to rise from the current 3.4% to 4.9% to represent "fair value" by historical standards, assuming no change in inflation expectations.

Such an increase is unlikely to be triggered by the end of QE2, which is fully discounted. A more probable source of upward pressure is a strengthening of corporate credit demand as economic recovery continues, resulting in a clash with government financing needs. Growth in corporate credit market debt outstanding rose from 4.5% to 5.5% annualised between the first and second halves of 2010, according to the flow of funds accounts.

While overall borrowing firmed, companies continued to repay bank credit during the second half. This has changed in early 2011, with banks' commercial and industrial loans rising at a 6.3% annualised pace in the first three months and by 11.3% in March alone – second chart. Stronger credit demand alongside increased hiring and M&A is evidence of a return of corporate "animal spirits", in turn suggesting rising risks for Treasuries.

* The 10-year inflation forecast in the Survey of Professional Forecasters starts in 1991. An equivalent measure from The Blue Chip Economic Indicators survey was used over 1979-91. For earlier years, expectations were proxied as a function of actual inflation.

A useful summary measure of whether the MPC is on track to meet the 2% inflation target is the Bank of England's mean projection two years ahead based on unchanged policy. In the February Inflation Report, this stood at 2.48%, representing the largest positive deviation from the target since February 1998 and clearly signalling the need for higher interest rates – see chart.

MPC doves, led by the Bank's Governor Mervyn King, have used two subterfuges to deflect media and market attention away from this glaring inconsistency. The first is to refer to the central or modal projection rather than the mean forecast. The central projection two years ahead assuming unchanged policy was 2.08% in February. The mean forecast also takes account of the skew of risks – judged to be weighted strongly to the upside currently. The inflation-targeting remit implies that the MPC should be equally concerned about over- and undershoots and it is reasonable to place greater weight on avoiding large deviations, in which case the mean forecast is the correct focus of policy.

The second trick is to refer to the forecast based on market interest rate expectations rather than unchanged policy. This allows the doves to take credit for market-implied tightening without ever delivering. In February, for example, the central and mean forecasts two years ahead incorporating the market interest rate path were 1.62% and 2.02% respectively. This, however, assumed an average Bank rate of 0.7% in the second quarter, implying a quarter-point rate hike in April or May – most economists expect continued inaction next month. In this way, the MPC can repeatedly push back the start date of tightening while claiming that policy is still consistent with the target, based on later significant interest rate rises discounted by the money market curve.

Also convenient for the Governor's "news management" is the convention of releasing the forecast numbers a week after publication of the Inflation Report. The central projection is more readily estimated from the Report's fan charts than the risk-adjusted mean. Journalists at the February press conference struggling to absorb a large volume of information understandably failed to spot the large overshoot of the mean forecast, enabling the Governor to escape difficult questioning on how this could be reconciled with unchanged policy. The caravan had moved on by the time the numbers barked a week later.

While these presentational tricks provide useful wriggle room, the doves can, of course, simply enforce a change in the forecast to suit their policy prescription, since the forecasting process is almost completely opaque and reliant on "judgement". The two-year-ahead projection, for example, was cut between May and August last year without credible justification as the doves sought to lay the foundation for a further expansion of QE, following the US lead given by their soul-mate Professor Bernanke. Reality – in the form of much higher inflation than the August Report projected – intervened to stymie these plans.

Will such an ad hoc downward adjustment be used to justify a further delay in raising rates at the May MPC meeting? As of yesterday, sterling's effective rate was 1.5% below the starting level assumed in the February Inflation Report while energy prices were significantly higher, factors arguing for an upward inflation revision. The doves, however, may resort to their favoured if tarnished "output gap" defence if next week's preliminary GDP release shows a smaller first-quarter rise than the 0.6-1.0% apparently factored into the February forecast (although business surveys and labour market trends suggest that official output statistics understate recent economic performance).

The opacity of the forecasting process and scope for creative interpretation of the remit and presentational manipulation imply that there is no effective constraint on the MPC's "discretion". Inflation-targeting has become meaningless.

Equities have lost traction recently, probably reflecting a less favourable monetary backdrop and consistent with behaviour at the equivalent stage of prior recoveries after large bear markets – see previous post. Credit markets also suggest a decline in risk appetite, with Euroland, corporate and emerging market yield spreads widening – see first chart.

Risk assets will continue to receive support from the Federal Reserve's liquidity injections. As of last Wednesday, the Fed's securities portfolio had expanded $400 billion from its level in early November when the $600 billion "QE2" programme was announced. Assuming no sterilisation, therefore, bank reserves at the Fed are on course to rise by a further $200 billion to $1.73 trillion by mid-year, equivalent to 11.5% of GDP versus a previous record (in 1940) of 6.9% – see second chart and earlier post.

Market strength in late March and early April, however, also reflected a surge in Japanese bank reserves following the 11 March tragedy, due to foreign exchange intervention to hold down the yen and an increase in Bank of Japan lending to stabilise the financial system – second chart. Reserves have fallen by $70 billion from the recent peak and may continue to decline if the central bank allows the lending rise to reverse as economic and financial conditions normalise. A return to the 11 March level would imply a further $200 billion drop.

The Bank of Japan, in other words, could neutralise the impact of the Fed's remaining liquidity injection unless it acts to sustain bank reserves at their recent higher level. The central bank, however, has announced only a modest expansion of asset purchases since the tragedy and is reluctant to target reserves, viewing such an approach as a throwback to the failed QE policy of 2001-06. Renewed yen strength may be necessary to force a more expansive stance.