A key tenet of this journal is that economic and market cycles are driven by deviations between the supply of money and the demand to hold it. When supply outpaces demand, there is “excess” money available for spending on goods and services or investment in financial assets.

The supply of money can be measured but demand, of course, is unobservable. Monetarists, however, assume that demand is relatively stable so that supply swings are the key determinant of whether there is “excess” or “deficient” money. This assumption is reasonable under normal economic conditions but can break down under extreme circumstances, as currently.

Recent posts have drawn attention to a surge in US money supply measures, suggesting an improving monetary backdrop for the economy, allowing for the normal lag of about six months. Some commentators, however, suggest that this surge has been matched or exceeded by a rise in the demand to hold US bank deposits, reflecting increased risk aversion. The economy, on this view, is in a “liquidity trap”.

Scott Grannis, for example, argues that US money demand has been boosted by massive capital flight from the Eurozone as investors anticipate a break-up of the single currency. The US money supply gain, however, has not, to date, been fully offset by Eurozone weakness – G7 monetary growth, therefore, has risen. Eurozone figures for July, released next week, could conceivably change the story but would need to show a large decline to offset US strength.

The Grannis theory of a huge capital inflow to the US from Europe, in any case, is inconsistent with the stability of the euro / dollar exchange rate in recent weeks.

Other commentators have suggested that the rise in US M2 reflects a transfer of cash from money substitutes into bank deposits, partly reflecting perceived risks surrounding the substitutes (e.g. institutional money funds with exposure to European banks). On this view, a broad liquidity aggregate including such substitutes would look much weaker than the conventional measures.

Again, however, the theory runs aground against the facts. The chart shows six-month growth in M2 and two broader measures – “M2+” including large time deposits and institutional money funds and a wider liquidity aggregate additionally incorporating commercial paper and Treasury bills. These alternative measures are less strong than M2 but have still accelerated significantly in recent months.

It is impossible to be sure but recent US money supply strength is unlikely to have been fully offset by a rise in liquidity preference due to the current crisis, so monetary support for the economy and markets should be increasing, though will operate with a lag. Liquidity preference, of course, would fall back in the event of confidence-building policy measures – admittedly difficult to imagine given recent abject performance but not impossible.

Numerous posts here over the last three years predicted that UK inflation would overshoot Bank of England and consensus forecasts. Since the spring, however, it has been suggested that CPI inflation would peak at a lower level and fall faster than generally expected, while remaining above the 2% target over the medium term.

The chart below shows updated profiles for CPI and RPIX inflation taking into account July outturns, which were broadly in line with expectations at the headline level but with some differences within the detail. CPI inflation is forecast to rise from 4.4% in July to a peak of 4.8% in September / October before falling sharply to 2.5% in April 2012.

RPIX inflation may already have peaked at 5.5% in February, though is projected to return to this level in October (from July’s 5.0%), before falling to 3.4% next April.

For comparison, the Bank of England expects CPI inflation to reach a quarterly-average peak of 5.0% in the fourth quarter of 2011, falling to 3.3% in the second quarter of 2012. The latter figure is 0.5 percentage points higher than implied by the forecast here.

The profiles in the chart are based on “core” prices rising at their recent rate (allowing for seasonal movements), with the projected sharp decline in late 2011 / early 2012 mainly driven by the VAT effect and falls in petrol and food inflation in lagged response to recent commodity price stabilisation. The forecasts assume a stable exchange rate – an important proviso.

The prospect of a larger drop over the next 12 months does not, of course, vindicate the MPC’s inaction in the face of the prior surge. On the forecast here, CPI inflation will remain above the 2% target through the end of 2012 and probably beyond. The index, moreover, is currently 5.5% above the level implied if the target had been met since the CPI was adopted as the reference measure in 2003. This overshoot implies a probably-permanent loss of purchasing power for savers who mistakenly based their investment decisions on an assumption that the MPC would fulfil its remit.

The August MPC minutes confirm that the Committee has shifted to an easing bias, as predicted by the “MPC-ometer” and signalled by last week’s Inflation Report.

A post two weeks ago noted that the MPC-ometer forecast was “consistent with Weale / Dale retracting their tightening votes and one or two members of the middle grouping moving into Posen’s camp. In reality, any shift is likely to be smaller, partly reflecting the difficulty of changing entrenched positions.”

While Posen remained formally isolated, some other members considered voting for more QE but concluded that the “case was not yet strong enough”, partly because market interest rate expectations had fallen, providing indirect stimulus.

The MPC-ometer prediction for September will not be finalised until the start of the month but the current indication is for a further dovish shift, based on information on about half of the inputs and an assumption that the others remain unchanged. The forecast “average interest rate vote” is -11 basis points, close to the -12.5 bp trigger for easing action – see chart. Assuming equivalence between a £50 billion QE expansion and a quarter-point rate cut, this is consistent with three other members voting with Posen next month.

The further move in the model mainly reflects deteriorating financial market conditions, with inflation indicators little changed. The final reading will depend importantly on forthcoming activity data, including the second-quarter GDP revision, August EU Commission consumer survey and August PMIs for manufacturing and services.

The following two charts highlight the monetary tensions in the global economic outlook.

The first chart shows that six-month growth in G7 real narrow money (i.e. an M1-type measure comprising cash and current accounts) rose to its highest level since May 2009 last month, based on preliminary data. Allowing for the normal lead of about six months, this is a positive signal for the global economy in late 2011 and early 2012.

Underlying this improvement, however, is a very unusual divergence between monetary strength in the US and Japan and weakness in the Euro area, as shown by the second chart. Viewing the Eurozone in isolation, falls in real narrow money on the current scale have only ever been observed before recessions.

The risk, therefore, to the hopeful global view expressed in these notes is that a downward economic spiral in the Eurozone, via direct and financial spill-over effects, neutralises or outweighs the impact of monetary stimulus elsewhere.

If the global economic upswing expires, the ECB’s finger-prints will be all over the murder weapon. The decision this year to increase interest rates despite a contracting real money supply ranks among the most egregious monetary policy blunders of recent decades, on a par with the Bundesbank undermining the Louvre accord to stabilise the dollar by hiking rates in 1987, thereby triggering the October stock market crash. ECB loosening – rather than an expansion of the EFSF, further fiscal retrenchment, structural reforms etc – is the key requirement for ending the Eurozone crisis.