Recent lower energy prices and stable food prices – if sustained – promise a significant slowdown in G7 headline inflation, which, in turn, would provide a further boost to real money supply expansion, thereby improving global economic prospects for late 2011 / early 2012.

G7 consumer price inflation has risen from 1.3% in October 2010 to 2.8% in April and may have reached 3.0% in May, based on available data (the Japanese CPI for May has yet to be released) – see first chart. Not all of the pick-up has been due to food and energy prices – core inflation has firmed from 0.7% in October to 1.3% by April.

The “wedge” between G7 headline and core inflation is closely correlated with the annual rate of change of the IMF all commodities price index – second chart. If commodity prices were to remain at yesterday’s levels, annual growth in the IMF index would slow from 35% to about 10% by late 2011, suggesting a fall in the headline / core inflation wedge from 1.5 to about 0.5 percentage points.

Core inflation is likely to continue to trend higher, reflecting earlier cost increases passing through the pricing chain and “second-round” effects, as firms and consumers resist erosion of real profits and wages. Assuming a rise to 1.5% by late 2011, a 0.5 percentage point wedge implies a headline G7 inflation rate of 2.0%, about one percentage point lower than currently.

The recent slowdown in global economic growth was signalled by a deceleration of G7 real narrow money expansion in late 2010. The six-month growth rate of real money, however, has moved up from 1.4% in February (not annualised) to 2.1% in April and is likely to have risen further in May, based on US and Japanese monetary data – third chart. Allowing for the normal six-month lead, this suggests that global industrial momentum will revive from the late summer. If so, manufacturing PMI new orders indices should start improving from July or August.

The coming inflation fall promises to sustain the real money pick-up. Six-month G7 real narrow money expansion of 2.1% in April reflected nominal growth of 4.4% and a 2.2% seasonally-adjusted rise in consumer prices. Assuming that commodity prices stabilise at their current level, the G7 CPI could be broadly flat over the next six months. Nominal money growth may slow following the end of US QE2 but not by enough to prevent a further rise in real expansion, in turn suggesting that the coming economic reacceleration will be sustained into early 2012.