A post in January 2010 suggested that the UK "output gap" (i.e. the shortfall of GDP relative to normal supply capacity) was 2% rather than 5-7%, as claimed by official forecasters at the time. This was a key reason for expecting inflation to continue to overshoot official and market expectations.

Forecasters, similarly, believed that the US output gap was large in early 2010 and would exert significant downward pressure on "core" inflation. This prediction, for a while, proved more successful than its UK equivalent – the annual increase in the CPI excluding food and energy slowed from 1.8% in December 2009 to 0.6% in October 2010.

CPI ex. food and energy inflation, however, has rebounded since late 2010, reaching 1.3% in April. An alternative core measure also excluding housing costs is running at 1.6%, in the middle of its range in recent years – see first chart.

The failure of core inflation to sustain a significant decline suggests that, as in the UK, the US output gap has been overestimated. This is supported by survey evidence. The second chart shows the OECD's estimate of the gap – representative of the consensus view – together with an economy-wide operating rate derived from the ISM's semi-annual business survey (a weighted average of manufacturing and non-manufacturing rates). The two measures have diverged since late 2009, with the current ISM reading consistent with an output gap of only about 1% rather than more than 3%, as claimed by the OECD.

Spare capacity, therefore, may offer limited check to an upswing in core inflation caused by monetary loosening and associated dollar weakness.

The government has been able to continue to fund the large budget deficit at low interest rates in recent months because banks and building societies have stepped up gilt purchases, compensating for a reduction in demand from non-bank domestic investors and overseas residents.

Banks and building societies bought £7.7 billion of the £12.8 billion of new gilts sold in April. Over the last six months, their purchases have totalled £36.1 billion, up from £11.4 billion in the prior half-year and equivalent to 91% of net issuance of £39.8 billion.

Overseas buying of gilts, by contrast, fell to £12.4 billion in the six months to April from £33.5 billion in the prior half-year, probably reflecting a slowdown in capital flight from struggling peripheral Eurozone economies. Non-bank domestic investors, meanwhile, sold £8.2 billion of gilts in the latest six months.

Banks are buying gilts partly under regulatory pressure but also because private sector demand for bank loans remains weak. Any revival in credit demand would probably slow the rate of purchases and put upward pressure on gilt yields. For the moment, banks are effectively delivering the QE2 stimulus sought by MPC arch-dove Adam Posen.

Monetary statistics for April also released today show continued weakness in the broad money supply (i.e. M4 excluding money holdings of intermediate other financial corporations, or M4ex). 12-month growth was unchanged at 1.5% while M4ex contracted by an annualised 2.0% in the latest three months. This weakness, however, is probably consistent with a continued economic recovery and inflation overshoot:

• Annual M4ex growth remains within the 0.5-2.5% range in operation since mid-2009. This has been associated with solid expansion of nominal demand and GDP – gross final expenditure rose by 6.2% in the year to the first quarter. The velocity of circulation of money, in other words, has risen and may continue to trend higher as long as real deposit interest rates remain heavily negative.

• The contraction of M4ex over the last three months was caused by money-holders switching into foreign-currency deposits (not included in M4ex), possibly in anticipation of sterling weakness. The addition to such deposits (excluding intermediate OFCs) was an unusually-large £22 billion over February-April. An expanded measure (i.e. M4ex plus foreign-currency deposits) rose by 3.2% annualised in the three months to April.

• Narrow money trends still appear satisfactory: "non-interest-bearing M1" (i.e. currency plus traditional interest-free current accounts) rose by 9.7% in the year to April.

The key ISM manufacturing new orders index may have dropped sharply in May, judging from already-released regional Federal Reserve surveys – see first chart. While the regional surveys show a slump in current orders, however, expectations remain relatively upbeat, suggesting that much of the weakness reflects temporary supply-chain disruption due to the Japanese earthquake. (The ISM survey is released tomorrow. Four of five Fed surveys have been released for May, with the Dallas Fed survey due later today.)

Japanese supply is coming back on line, with manufacturing output up by 1.0% in April and expected to rise by 16.3% over May-June, according to figures released today. The suggestion that ISM new orders will rebound from a May low is also supported by the latest Federation of Korean Industries survey, which often leads the ISM and shows a recovery in manufacturing expectations following weakness last month – second chart.

Intermediate-maturity Treasury yields tend to mirror changes in ISM new orders – third chart. Yields appear to have discounted a further ISM decline in May and could move back up if orders rebound over the summer.

As discussed last week, US monetary trends remain expansionary, suggesting solid economic growth over the remainder of 2011. Money of zero maturity (MZM) – comprising currency, checkable deposits, savings deposits and money funds – rose at an 11% annualised rate over the last 13 weeks, up from 2% over the prior three months. Swings in short-term MZM expansion often lead Treasury yields – fourth chart.