US “money of zero maturity” – a money supply measure comprising currency and instant-access deposits – surged by 1.6% in the two weeks to 4 July, pushing three-month annualised growth up to 15.1%.

Within MZM, M1 – currency plus checkable deposits – rose by 3.0% over the fortnight and 21.7% annualised over the last three months.

A build-up of cash in instant-access accounts usually signals that consumers / firms are planning to boost spending or investment in markets, with bullish implications for the economy and asset prices. On this occasion, however, the rise may partly reflect increased risk aversion and liquidity preference induced by the political dead-lock over raising the debt ceiling.

Liquidity, nevertheless, should flow back into the economy and markets in the likely event of an agreement – even if only on a short-term fix.

Last year, the MPC warned that interest rates would have to rise if inflationary expectations became detached from the 2% target. In the June Citigroup / YouGov survey of households, the median forecast for inflation over the next 5-10 years rose to 4.1% – the highest in the survey’s five-year history.

More recently, MPC members have focused on pay trends rather than inflationary expectations as a possible trigger for policy tightening. For example, in a submission last month to the Treasury select committee David Miles said, “There is little evidence that any rise in inflation expectations has led to higher wage growth. Without a pick up in wage inflation I do not think it likely that inflation being significantly above target is sustainable.”

Private-sector regular earnings (i.e. excluding bonuses) rose by 2.6% in the year to May – the largest annual increase since January 2009. Growth averaged a slower 2.1% over the last three months but was depressed by the additional April bank holiday, which resulted in a fall in average weekly hours compared with a year ago (the earnings figures measure weekly pay). The 2.6% May increase, therefore, is probably a better guide to the trend.

The median private-sector pay settlement has fluctuated between 2.5% and 3.0% in recent months, according to Incomes Data Services. Under normal circumstances, annual growth in regular earnings is higher than a 12-month moving average of settlements, reflecting “pay drift” – the additional boost to wages from progression, interim adjustments and restructuring outside the annual review. Pay drift was running at 0.3 percentage points in early 2011 and averaged 0.6 pp over 2001-07, according to the Bank of England (May Inflation Report, p.37). Assuming no further change in settlements and a firming of pay drift in response to better second-half economic performance, private earnings growth could rise to 3.0-3.5% by early 2012.

Historically, earnings growth of 4% has been viewed as consistent with the 2% inflation target based on trend productivity (output per hour) expansion of 2% per annum. Productivity performance, however, has weakened and trend growth may now be 1.5% or less, as explained in a previous post. With the low level of sterling maintaining upward pressure on import prices, moreover, domestic unit labour costs probably need to rise by less than 2% pa for the inflation target to be met.

A rise in private-sector earnings growth to 3.0-3.5%, therefore, ought to ring inflationary alarm bells even among the MPC’s doves.

A deepening Eurozone debt crisis could disrupt the scenario but G7 real money trends continue to point to a recovery in global economic momentum during the second half.

The first chart shows six-month growth in G7 industrial output and real narrow money. The latest real money plot is an estimate for June, incorporating US and Japanese monetary data and European CPI numbers. Real money expansion picked up further last month and may have reached its fastest pace since 2009.

Real money leads output by between six months and a year. Growth bottomed in February so output momentum should revive from August at the earliest and February 2012 at the latest. An early turnaround is more likely because the slowdown in economic momentum in response to earlier monetary weakness was exaggerated by Japanese supply disruption, which is now reversing.

G7 narrow money has been growing solidly in nominal terms, with US and Japanese strength offsetting European weakness. The rise in real expansion in June, however, was driven by a slowdown in CPI inflation – second chart. Barring a renewed surge in commodity prices, this slowdown should extend, as discussed in a previous post. The inflation drag on growth, in other words, is reversing.

Emerging-world monetary trends are weaker than in the G7 but lower headline inflation will improve economic prospects by supporting real money expansion and relieving pressure for further policy tightening. E7 economies remain closely tied to the G7 cycle and are usually early to pick up shifts in global momentum. A leading indicator of E7 industrial output expansion derived from OECD data improved marginally in May – third chart.

The promising economic outlook suggested by monetary trends, of course, could be wrecked if Eurozone policy-makers fail to stem the current crisis, or if the Federal Reserve uses recent economic weakness as an excuse to launch more QE, resulting in a further surge in commodity prices.

A post in May suggested that CPI inflation would undershoot the Bank of England’s forecast over the next 12 months while remaining well above the 2% target over the medium term. The fall from 4.5% in May to 4.2% in June supports this prediction, although part of the favourable surprise reflects an earlier-than-usual start to summer sales and should be reversed next month.

The earlier post suggested that inflation would peak at 4.6% this autumn and fall below 3% in early 2012. In its May Inflation Report, by contrast, the Bank forecast a quarterly-average peak of 5.0% and a slower decline, with a two handle regained only in mid 2012.

Despite today’s better news, the inflation peak is likely to be slightly higher than indicated in the previous post because the outlook for household energy prices has deteriorated, following the announcement by market leader British Gas of gas and electricity rises of 18% and 16% respectively. The chart shows an updated profile taking into account the June figures and higher energy prices but otherwise based on the same assumptions as previously. The new suggested high is 4.8% in September / October.

Previously-targeted RPIX inflation may already have peaked at 5.5% in February, as mooted in another recent post. It fell to 5.0% in June and may rise by less than CPI inflation because of soft house prices and a slower rise in insurance premiums (which have a larger weight in the RPI than CPI).

Italian government bonds have come under pressure partly because the country’s economic recovery has ground to a halt, as reflected in very soft June purchasing managers’ survey results. (Italy’s composite PMI fell to 48.4, below the 50 break-even level and lower than Spain’s 49.2.) As usual, economic weakness was signalled six months in advance by real narrow money, which started to contract in late 2010, a development discussed in a post in December.

In general, narrow money M1 is a better leading indicator than broader measures. In the ECB’s statistics, M1 comprises currency in circulation and overnight deposits. The ECB publishes a geographical breakdown of deposits but not currency. The first chart shows six-month changes in real overnight deposits for the four large economies. Italian weakness is extreme, with a faster rate of contraction than before the 2008-09 recession.

In late 2010, in contrast to Italy and Spain, real deposits were still growing in Germany and France, implying respectable economic prospects for the first half of 2011. Now, contraction is occurring even in the core, while the pace of decline in Spain has moderated. This suggests that the recent “two-speed” Eurozone economy will give way to generalised weakness during the second half, though with Italy underperforming.

The second chart compares Italy and Spain with the other peripherals. Ireland has recently decoupled from rapid declines in Greece and Portugal, suggesting a smaller risk that renewed recession will undermine fiscal plans and trigger a second bail-out.

Among core economies, real overnight deposits are contracting at a similar pace to Greece / Portugal in Austria and Belgium – third chart. Belgian government yields have been eerily stable in recent days, despite the country’s high debt – the Italian / Belgian 10-year spread has blown out to 160 basis points (Tuesday 9.00am) from 40 bp in mid May.