Last week’s Inflation Report was regarded as slightly hawkish but I was struck by the forecast based on unchanged interest rates, showing an annual CPI increase of just 1.77% in the first quarter of 2010. Despite two rate cuts and a sharp fall in sterling, this was only 3 bp higher than the two-year-ahead forecast in November’s Report and represents the second largest shortfall from target in the MPC’s history.

The message was reinforced by today’s minutes of the February meeting, showing an 8-1 vote in favour of the quarter-point cut, with David Blanchflower dissenting in favour of a 50 bp move. This is considerably more dovish than the 5-4 split suggested by both my MPC-ometer and the Sunday Times Shadow MPC.

In light of this information, and ongoing deterioration in credit markets, I now expect an early further cut in rates despite the prospect of a surge in CPI inflation to 3% by the third quarter of 2008. I will be guided by the MPC-ometer but a move seems likely before the next Inflation Report in May.

My personal view is that rates should be held at 5.25% until inflation is over its hump. The MPC’s mandate is to meet the 2% target “at all times” not just at the two-year horizon. It is true that its policy actions have a negligible effect on near-term inflation prospects but they are relevant one year ahead, when the Inflation Report suggests the annual CPI increase will still be well above target, at 2.29%.

Media comment has focused on the risks but the nationalisation of Northern Rock could prove extraordinarily profitable for UK taxpayers – assuming the government can avoid making a significant compensation payment to equity and subordinated debt holders.

Despite Treasury guarantees, Northern Rock has been forced to offer high interest rates to retain its retail deposit base, with savers concerned that their accounts would be frozen in the event of the bank going into administration. (Including a temporary loyalty bonus, Rock’s tracker online account currently pays a 6.99% AER.) Nationalisation removes this liquidity risk and should allow the bank to reduce its retail funding costs significantly.

European Union state aid requirements imply the Bank of England will continue to charge a penal interest rate on its loan but this now represents a transfer within the public sector.

On the assets side, the aim will be to shrink the mortgage book to allow early repayment of the Bank of England’s loan. New lending will be negligible and mortgage rates will be raised to encourage existing borrowers to refinance elsewhere. Assuming they stay, this will add to the boost to profitability from lower funding costs. Job losses are also inevitable, reducing the bank's cost base.

The key concern is that housing market weakness coupled with possible adverse incentive effects from public ownership will lead to significant default losses. Northern Rock had £97 billion of customer loans at 30 June 2007 but credit risk on £46 billion of the total had been partially transferred to holders of securitised notes.

In the housing recession of the early 1990s repossessions nationally reached a peak of 0.77% of outstanding mortgages in 1991. Assume Northern Rock is forced to foreclose on 1% of its loans each year for three years and achieves a recovery rate of only 70%. Based on a £97 billion book, this would imply a loss of £850-900 million, of which about £150 million might fall on holders of securitised notes. Northern Rock’s shareholder funds stood at £2.3 billion at 30 June 2007. Even assuming significant erosion since, the remaining equity in the business should easily absorb any losses barring an Armageddon scenario for the housing market.

A large divergence has recently opened up between survey-based measures of economic activity and “hard” data released by official statistical insitutions.

The hard information has been holding up reasonably well, examples last week including US retail sales and industrial output and Japanese and Eurozone GDP. As the first chart below shows, G7 industrial output growth has been following my soft landing scenario closely.

Surveys, by contrast, have deteriorated sharply over the last month, in some cases to an extent suggesting recession. For example, the earnings revisions ratio from the IBES survey of equity analysts plunged to a seven-year low in February – see second chart. Marked weakness was also on display in reports last week on US consumer sentiment, US small firm optimism, Japanese consumer confidence and German investor sentiment.

Under normal circumstances survey-based information provides a useful lead on hard economic data. However, sentiment weakness may have been exaggerated by negative credit market news and the Fed’s “emergency” rate cuts, which suggested the central bank expected a recession.

I am inclined to give greater weight to the hard data but will be concerned if the deterioration in sentiment is sustained and confirmed across a wider range of surveys. In the Eurozone, this week’s “flash” PMI readings will provide an important litmus test.

The extent of near-term global economic weakness is unclear but I still expect an improvement later in 2008 as recent monetary loosening offsets tighter credit conditions.

The UK authorities have been unhappy with the use made of the weekly Bank of England return to estimate the Bank’s lending to Northern Rock and are proposing to abolish it.

Central bank transparency is an important principle that should not be discarded lightly. The claimed benefit of increased operational flexibility is dubious.

A letter to the Financial Times opposing this change can be found here.

I am away for a few days and will post again next week.

The statement accompanying last week’s UK rate cut referred to elevated inflation expectations as posing an upside risk to medium-term inflation prospects. However, some economists argue that survey-based expectations measures provide little information about future inflation, with activity indicators playing a much more significant role.

To test such claims, I examined the statistical relationship between consumer price inflation one and two years ahead and measures of confidence and inflation expectations from the monthly European Commission surveys of households and manufacturing firms. The inflation measures are shown in the first chart below. (They are based on percentage balances of households and firms expecting higher prices.)

To summarise the results, inflation expectations of both households and manufacturing firms are useful for forecasting CPI inflation one year ahead but lose power at the two-year horizon. When combined with confidence measures, manufacturing inflation expectations retain significance at the one-year horizon but household expectations contain little additional information.

These results argue for caution in cutting rates any further until business inflation expectations subside but the MPC should be less exercised by high household expectations, at least while consumer confidence is weakening and there is limited evidence of pass-through to wages.

The MPC will use this week’s Inflation Report to signal its intentions. A useful summary measure of its bias is the mean inflation forecast two years ahead assuming unchanged rates. The November forecast, at 1.74%, was further below the inflation target than in any previous Inflation Report since the MPC’s inception, a clearly dovish signal – see second chart.

With Bank Rate down by 50 bp since November, and sterling’s effective rate 7% weaker, the new forecast is likely to be much closer to the 2% target. The extent of any negative deviation will indicate the Committee’s residual easing bias following last week’s cut.

There is a scare story doing the rounds about US banks “running out of cash at the Fed”. This is based on the Fed’s H.3 statistical release, showing that “non-borrowed reserves of depository institutions” (second column of table) turned negative in the latest fortnight.

The story revolves around a misunderstanding. The Fed supplies cash reserves to the banking system either via sale-and-repurchase agreements (repos) or lending from the discount window or more recently under the Term Auction Facility. Only repo-sourced reserves are classified as “non-borrowed”.

Banks have recently taken advantage of the TAF to source their needed reserves so repos have fallen, pushing non-borrowed reserves into negative territory. However, total reserves have remained stable (first column) and above the level dictated by reserve requirements (third column). There is no aggregate shortage of cash at the Fed. Banks have chosen to use the TAF because they can obtain longer-term funds against a wide range of collateral.

If there were any shortage of cash the fed funds rate would be trading above the Fed’s 3.0% target. It has been below the target on average so far this week.

Fear levels are about as high as they get when such stories are taken seriously.