Are markets too focused on prospective monetary easing in the US and, possibly, the UK, neglecting policy restriction elsewhere?

China delivered a "surprise" interest rate hike last week but, in addition, the ECB has been "tightening by stealth". The expiry of long-term refinancing operations has resulted in a 19% contraction in the monetary base since late June, contributing to three-month Euribor moving above 1.0% versus a first-half average of below 0.7% – see first chart.

The Eurozone reduction has been the main driver of a 7% fall in the G7 monetary base over the same period. World equities have tracked the G7 base since the Fed launched "QE1" in late 2008 but a large gap has opened up recently, suggesting that markets have already priced in an additional injection of about $400 billion – second chart.

An important issue is whether the Fed chooses to sterilise the monetary base impact of the additional asset purchases it will, presumably, announce next week. "QE1" was accompanied by the introduction of the "supplementary financing programme" (SFP), under which the Treasury issues additional bills to soak up liquidity created by the Fed. The SFP has been static at $200 billion in recent months.

In a recent speech, Fed Chairman Bernanke referred to asset purchases providing stimulus by lowering longer-term interest rates rather than boosting the monetary base, suggesting that he would be comfortable with a fully- or partially-sterilised operation. A "QE2" initiative accompanied by an increase in the SFP would probably deliver less "bang for the buck" in terms of wider market impact.