UK producer output prices rose by a stronger-than-expected 0.5% in January, consistent with manufacturing inflationary pressures remaining sticky.

The annual increase slowed but was still a chunky 4.1% last month. Optimists, however, will point to a fall in “core” annual inflation (i.e. excluding food, beverages, tobacco and petroleum) from 3.0% in December to 2.4% – the lowest since February 2010.

The recent reduction was signalled by a decline in the price expectations balance of the CBI industrial survey during 2011 but this remains above its long-run average and recovered over year-end – see chart. The suggestion is that core inflation will stabilise around the current level or even revive.

The view here has been that the Bank of England and the consensus are, once again, overestimating disinflationary forces and that the 12-month CPI increase, rather than falling below target by late 2012, may bottom at about 2.5% in the autumn and move higher in 2013. Such a scenario, of course, would imply that yesterday’s MPC decision to expand QE by a further £50 billion was a mistake.

The forecasting approach employed here relies on three simple “monetarist” rules:

• The real money supply leads output by about six months.

• The nominal money supply leads prices by about two years.

• Markets do better when real money is growing faster than output.

The first two stem from the empirical work of Friedman and Schwarz – see also here – while the third is a monetarist market rule-of-thumb, based on the idea that faster growth of real money than output implies “excess” liquidity available to push up asset prices.

These simple rules have outperformed consensus predictions over the last year, continuing a longer-run record of success.

The first rule was the basis for a forecast here last autumn that global economic momentum would pick up into early 2012, in contrast to consensus worries of a US “double dip” and Eurozone implosion.

The second rule was used last spring to predict a peak in G7 inflation in autumn 2011 followed by a modest decline in 2012, a forecast that also appears on track.

The third rule forms the basis for an investment strategy discussed here previously, involving switching between equities and cash depending on whether the annual growth rate of G7 real narrow money is greater or less than that of industrial output. A conservative form of the strategy buys equities six months after a positive real money / output cross-over but sells immediately on a reversal.

The chart compares the historical return on this strategy relative to US dollar cash with that of buying and holding equities. The strategy has beaten buy-and-hold by an average of 3.7 percentage points per annum over the 42 years since 1969.

The strategy outperformed again in 2011, staying in cash during the first nine months of the year before switching into equities in time for a fourth quarter rally. It returned 7.6% more than cash for the year versus a 5.3% loss for buy-and-hold.

The three rules currently suggest that 1) the global economy will expand respectably during the first half of 2012, 2) inflation will trough around the middle of the year and move up into 2013 and 3) equities remain attractive relative to cash. See previous posts here and here re 1) and 2).

Investors are better able to exploit a successful forecasting method when it is not widely employed. The monetarist approach, fortunately, remains deeply unfashionable with an economics herd obsessed with short-term data watching and dissecting the pronouncements of clueless policy-makers.

The Dow Industrials index is stronger than would be expected based on average experience after prior bear markets of a similar scale to 2007-09. This “overshoot” may reflect extraordinarily loose monetary conditions.

The table compares the 54% decline in the Dow between October 2007 and March 2009 with the seven worst bear markets of the last century. Six of the seven were of similar scale, involving a fall of between 45% and 52%. The outlier, of course, was the 1929-32 bear, when the Dow plunged by 89%.

The six similar bear markets can be used to “benchmark” recent Dow performance. First, the peak of the Dow before each bear was aligned with the October 2007 high and subsequent levels calculated. An average of the six levels was then taken at each date – this “six-bear average” shows a hypothetical path for the Dow based on mean experience after prior peaks.

Secondly, the trough of the Dow after each bear was aligned with the March 2009 low and subsequent levels calculated. An average of these six levels shows a hypothetical path for the Dow based on mean experience after prior troughs – a “six-recovery average”.

The chart compares the Dow’s performance with these two averages. Though derived independently, the averages trace out similar paths after late 2009. The Dow fluctuated above and below the averages during 2010 and 2011. These over- and undershoots correlate with changes in monetary conditions caused by the Fed starting and stopping QE operations, with ECB policy apparently also an influence recently.

For example, the fall in the Dow below the averages in mid 2010 followed the end of QE1 securities purchases in March. The launch of QE2 later in the year, however, was associated with a renewed surge, pushing the index to a significant overshoot by early 2011. Another correction occurred after QE2 ended in June last year, with weakness exacerbated by wrangling over the federal debt ceiling and Eurozone sovereign debt woes. This sell-off reversed following a series of Fed and ECB actions in late 2011, including the initiation of “operation twist” in September, the ECB’s reintroduction of one-year repos in October, an injection of dollar liquidity via Fed swaps with other central banks in November and the ECB’s extension of subsidised lending to three years against looser collateral requirements in December.

The Dow is now further above the averages than in early 2011 but strength is probably warranted by extraordinarily loose global monetary conditions, as evidenced by a large gap between G7 real narrow money and industrial output expansion and record G7 bank reserves. Investors, however, should be prepared for continued volatility: another wrenching correction is likely when monetary conditions tighten, either because central banks dial back on stimulus or stronger economies divert liquidity away from markets – a possible scenario for later in 2012.

The view here that the UK will avoid a “double dip” is supported by recent strength in online job vacancies – a good coincident indicator.

The Monster employment index is a monthly tally of vacancies posted on job boards and career websites. The index tends to lead official vacancies numbers and is available earlier – a January figure was released on Friday. A further advantage is that the Monster measure is ignored by the consensus.

The first chart shows a monthly estimate of GDP derived from output data on services, industry and construction (99% of the economy) together with a seasonally-adjusted version of the Monster index. The Monster survey correctly signalled a collapse in output between February 2008 and March 2009 and a subsequent recovery to a high in early 2011.

The Monster index weakened during the middle of last year but reached a low in October – monthly GDP troughed in the same month, based on current output data. It has since recovered strongly, matching its January 2011 high last month, suggesting that GDP has opened 2012 above its fourth-quarter level.

The index also implies a reversal of the recent fall in employee numbers – second chart.