At this morning’s level of 77.5, sterling’s effective exchange rate has fallen by almost 4% since MPC member Paul Fisher decided to confide his QE2 leanings to the Daily Mail a month ago. Was this the intended result? With the short-term inflation outlook improving at the margin as global commodity price pressures abate, Mr Fisher and his fellow MPC doves may think it opportune to launch another assault on the exchange rate in pursuit of the holy grail of “rebalancing” and manufacturing resurgence.

The effective rate is rapidly closing on its 10 March trough of 76.8, below which the next obvious stopping point is the all-time low of 73.7 reached in December 2008.

A post in January argued that the MPC’s policy inaction in the face of a continued inflation upswing risked a “double dip” in sterling as real interest rates moved deeper into negative territory. A comparison was drawn with the 1970s, when the exchange rate entered a second leg down after a year-long period of stability as the inflation / interest rate gap was similarly allowed to widen.

Sterling’s recent sideways trading has lasted much longer – two and a half years – but MPC members are deluded if they think this stability would survive the launch of QE2. The chart – an update from the previous post – overlays exchange rate performance during the 1970s on recent movements and is showing ominous signs of reconnection with the earlier debacle. (The chart aligns the peak in December 1971 with July 2007, which marked the start of sterling’s first plunge. July 2011 is the equivalent of November 1975.)

Equities and other risk assets have been sensitive to shifts in central bank liquidity since the dramatic easing that followed Lehman’s collapse in September 2008. A post in early June noted that combined bank reserves at the Fed, Bank of Japan and ECB were edging higher again, implying increased support for markets.

The rise has since continued, resulting in G3 reserves reaching a new record high and helping to explain this week’s strong equity rally – see first chart. Unexpectedly, the recent increase is the result of stepped-up liquidity provision by the BoJ and ECB rather than the tail-end of QE2 in the US. The Japanese infusion may have been a response to yen strength and has succeeded, at least for now, in capping upward pressure on the currency – second chart.

The rise in ECB reserves is a reflection of a recent increase in demand for funds at the weekly refinancing operations as funding for weaker banks has dried up in response to the latest Greek crisis.

US reserves remain below their mid June level despite further QE2 operations because the Treasury has increased its cash balance at the Fed, possibly as a precautionary measure in case negotiations over raising the debt ceiling fail. The balance in the Treasury’s general account rose from $23 billion to $106 billion between 8 and 29 June. Reserves should move above the prior high as this cash is released back into the system over coming weeks.

Barring a surprise reversal of the recent BoJ and ECB injections, therefore, central bank liquidity will remain a near-term support for markets.

Gilt yields were suppressed this spring by further semi-compulsory purchases by banks along with a pick-up in foreign buying, probably related to capital flight from the Eurozone as sovereign debt worries mounted.

The Debt Management Office issued £16.1 billion of gilts in May, while UK banks and overseas investors each bought £7.4 billion, with the rump taken up by domestic non-banks. Bank purchases totalled £33.5 billion, or 69% of net issuance, in the six months to May. Overseas buying in May was the strongest since December, in the wake of the Irish bailout – see first chart.

With banks' liquid asset holdings at their highest for nearly 30 years, according to the recent Financial Stability Report, gilts are vulnerable to a slowdown in their buying, as well as reduced foreign purchases if a Greek financial support deal calms Eurozone debt markets.

Other features of today's monetary statistics for May include:

• Broad money (i.e. M4 excluding holdings of intermediate other financial corporations, or M4ex) rose by 0.3% in May, reversing a 0.1% fall in April. Annualised growth was only 1.0% in the latest three months but – as previously discussed – has been depressed by money-holders switching from sterling into foreign currency deposits, possibly in (correct) anticipation of exchange rate weakness. UK residents' currency deposits at UK banks, excluding holdings of intermediate OFCs, increased by the equivalent of 1.0% of M4ex in the three months to May (unadjusted, not annualised).

• Narrow money trends have improved, with M1 rising by 9.7% annualised in the three months to May, following a contraction in late 2010 / early 2011. M1 is a better leading indicator than broad money and more weight should have been given here to its earlier weakness, which signalled recent economic sluggishness. The pick-up since early 2011 suggests improving economic prospects for the second half of the year.
  

• The corporate liquidity ratio – sterling and foreign currency bank deposits of non-financial corporations divided by bank borrowing – recovered in April and May after a first-quarter dip. Excluding property companies, the ratio is at its highest level on record in data extending back to 1998 – second chart.



The forecast of a reacceleration in G7 industrial momentum later this summer – based on faster real money supply growth since early 2011 and an unwind of Japan supply disruptions – is supported by today's Federation of Korean Industries survey for June.

Korean indicators are often early to detect shifts in global momentum, reflecting the economy's orientation towards exports (52% of GDP in 2010) and intermediate goods production. A slump in FKI manufacturing expectations this spring foreshadowed a sharp fall in G7 PMI new orders – see previous post.

Korean expectations recovered modestly in May, maintaining the improvement in June – see chart. This suggests that G7 new orders bottomed in May or, more likely, June.

Today's US Richmond Fed manufacturing survey provides a further hint of revival, with current and expected new orders rising in June, bucking the trend of weakness in earlier surveys from other regions.

The additional 29 April bank holiday has complicated interpretation of recent UK statistics, which have consequently received limited coverage here. Purchasing managers' surveys for June to be released over 1-5 July will provide important guidance about the state of the economy. One hopeful sign is that revisions to analysts' forecasts for company earnings have been balanced over the last month, following net downgrades in May. The PMIs correlate with earnings revisions – see first chart.

Last week's public finance numbers evoked much gloom about fiscal prospects. Borrowing in April and May combined was £1.5 billion higher than a year before but the comparison is distorted by the £3.5 billion bank payroll tax paid in April 2010. A six-month moving average of seasonally-adjusted borrowing continues to decline slowly – second chart. The recent rate of improvement, if sustained, implies a deficit of £125-30 billion in 2011-12, above the OBR's £122 billion forecast but down from £143.2 billion in 2010-11.

A previous post suggested that CPI inflation would undershoot the Bank of England's mean prediction of a rise to 5.0% in the third and fourth quarters of 2011. This prospect has been strengthened by the recent reversal in wholesale energy prices, which should result in a significant decline in motor fuel costs – third chart – while tempering coming utility price rises. The fuel effect is likely to shave 0.2% from the CPI relative to its May level, based on an unleaded price of £1.30 per litre (motor fuel has an index weight of 4.3%).