Contrary to the consensus interpretation, recent inflation news has been distinctly poor, with the cut in VAT and lower fuel prices masking a deteriorating underlying trend due to surging non-energy import costs.

The superficial view is that prices are slowing fast, with annual headline consumer price inflation down to 3.0% in January from a peak of 5.2% last September. However, using the CPI at constant tax rates, which adjusts for the reduction in VAT, the decline has been much smaller, from 5.0% to 4.1%. Moreover, this fall is fully explained by a drop in energy price inflation.

Underlying inflation is often measured by the CPI excluding unprocessed food and energy. The annual increase in this index declined from 2.8% to 1.9% between September and January but would have risen – to an estimated 3.0% – without the VAT reduction.

The culprit is the officially-sanctioned plunge in the exchange rate and a resulting large rise in non-energy import costs (import prices of manufactured goods climbed 14% in the year to December). Today’s Office for National Statistics release notes upward contributions to annual CPI inflation from a range of categories dependent on foreign suppliers, including games and toys, furniture, household and personal appliances and package holidays.

The recession will restrain domestically-generated inflation but higher import costs may continue to have an offsetting impact, barring a significant exchange rate rally. Energy effects will ensure a further fall in the headline CPI increase over coming months but the decline may disappoint MPC and consensus expectations and inflation will rebound in early 2010 as VAT and energy benefits reverse.

The plunge in the exchange rate has worsened the credit crunch by damaging banks’ capital ratios.

In its October Financial Stability Report, the Bank of England estimated that the tier 1 ratios of Barclays, Lloyds TSB and HBOS would stand at over 11%, 12.1% and 12.0% respectively after last autumn’s capital-raising. However, Barclays recently reported a ratio of only 9.7% at the end of 2008 while Lloyds HBOS has indicated a group outturn “in excess of 9%”. These levels are well above the Financial Services Authority’s minimum of 6-7% but imply a much smaller cushion than previously thought.

The declines appear to be due less to losses than strong growth in risk-weighted assets – the denominator of the tier 1 ratio. This growth in turn reflects both higher risk weightings – caused by the unhelpful pro-cyclicality of Basel Accord rules – and the decline in the exchange rate, which has boosted the sterling value of foreign-currency assets. (The sensitivity of capital ratios to currency movements reflects a mismatch between capital – held mostly in sterling – and assets, which contain a large foreign element.)

Current UK exchange rate policy is reminiscent of Japan in the late 1990s. With US approval, the Japanese authorities engineered a large fall in the yen in an effort to reflate the economy via net exports. However, this worsened a credit crunch by forcing capital-constrained banks to cut back domestic lending to compensate for a higher yen value of their foreign assets. The policy even failed to stimulate trade – the yen’s depreciation helped to topple other Asian currencies and resulting deep recessions damaged Japanese exports.

The charts below update an earlier analysis comparing GDP performance in the current recession with the last three – 1974-75, 1979-81 and 1990-91. As before, the GDP measure adjusts for the impact of strikes, while the lower chart also includes Bank of England and Treasury forecasts, contained in the February Inflation Report and November Pre-Budget Report respectively.

GDP in the fourth quarter of 2008 was 2.1% below the peak level reached in the second quarter, according to current Office for National Statistics (ONS) estimates. This compares with a peak-to-trough fall in strike-adjusted GDP of 2.5% in 1990-91, 2.8% in 1974-75 and 6.2% in 1979-81.

As explained here, however, monthly ONS numbers for services and industrial output imply that GDP in December was 1.0% below the fourth-quarter average. In other words, even assuming no further fall in early 2009, first-quarter GDP will be 3.1% below the peak level of the second quarter of 2008. So the current downturn is already deeper than the 1974-75 and 1990-91 recessions.

The Bank of England central forecast, based on a constant 1% Bank rate, entails GDP bottoming in the second / third quarters at a level 3.8-3.9% below the peak, implying a further decline of 0.8% from the estimated December reading. It then embarks on a strong recovery, rising at an annualised rate of about 3.5% over the following six quarters.

Strike-adjusted GDP fell by 6.2% in the 1979-81 recession. This dismal performance, however, was partly a reaction to a 5.3% surge in GDP in the year preceding the peak. With no comparable boom leading up to the current downturn, the Bank of England’s forecast that the current recession will be less severe is defensible, though depends on an improvement in money and credit conditions.

The Treasury forecast looked optimistic even when it was published in November – see here – and has been rendered obsolete by the fourth-quarter GDP estimate. The April Budget will probably be based on a profile similar to the Bank’s latest forecast.

Monetary news has improved recently: nominal money expansion may be stabilising, real growth is reviving as inflation falls and the MPC is finally embracing necessary quantitative action. This supports the Bank of England’s forecast that the economy will trough by the third quarter, though GDP could decline by more than it projects in the interim. However, monetary growth would need to rise substantially to justify the Bank’s projection of a strong recovery from late 2009, particularly with fiscal policy set to tighten next year. On current information, an economic revival is more likely to follow the pattern of the early 1980s and early 1990s, when GDP growth averaged only 1-2% annualised in the six quarters following the recession trough.

An earlier post drew attention to a statistical tendency for the exchange rate to weaken when Bank of England Governor Mervyn King gives a speech or appears at an Inflation Report press conference. In 12 such instances between August 2007 and November 2008, the average daily fall in the sterling effective index was 0.5%.

Mr. King gave a dinner speech on 20 January and presented at yesterday’s press conference. The sterling index dropped by 1.6% on 21 January and 1.5% yesterday. Intriguingly, it also fell on the preceding days – by 2.7% on 20 January and 1.3% on Tuesday. Are markets beginning to anticipate the “King effect”?

Today’s Inflation Report signals that the MPC sees little mileage in further cuts in Bank rate and will soon start buying gilts as well as corporate securities with the explicit aim of boosting the supply of broad money. This shift is significant and welcome but the new policy needs to be implemented swiftly to affect macroeconomic outcomes this year.

The central growth and inflation projections in the Report stretch plausibility, with GDP forecast to recover rapidly from the third quarter and annual CPI inflation below target as far as the eye can see, despite sterling’s plunge and next year’s VAT hike. There is a suspicion that the MPC is downplaying inflation risks to justify its new policy of printing money.

Further points:

• The Report argues that additional cuts in Bank rate might provide little stimulus, either because banks fail to pass them on to borrowers or their own interest margins are squeezed, damaging earnings and lending capacity. The MPC is therefore close to embarking on quantitative action beyond the current Asset Purchase Facility (APF) remit. Specifically, the APF will be expanded in scope and scale and financed by creating bank reserves.

• The Bank of England’s adjusted M4 measure – excluding financial intermediaries – rose by just 3.8% in the year to December. To bring the annual growth rate up to, say, 8%, adjusted M4 would need to expand by about £70 billion. The Bank’s asset purchases are unlikely to have a one-for-one impact on M4 so the buying programme may need to exceed £100 billion to have the required impact on monetary trends.

• While it is difficult to infer precise figures from the chart, the central growth projection based on unchanged interest rates is consistent with GDP declining by about 1.25% and 0.5% respectively in the first and second quarters before stabilising in the third. It then embarks on a strong recovery, rising by more than 0.75% per quarter over the following year. This is not impossible but looks unlikely barring an early substantial pick-up in money growth.

• The central inflation forecast shows the annual CPI increase falling to a trough of about 0.75% in the fourth quarter, recovering to 1.25% in the first quarter of 2010 as the recent VAT cut is reversed but slumping back below 1% later in 2010 and in 2011. The 2010 numbers look suspiciously low given the VAT change and likely lagged effects of the large fall in the exchange rate (manufactured import prices rose 14% in the year to December).

• The Report assumes the December VAT cut lowered the CPI by about 0.75 percentage points. This implies that annual inflation will rise by 0.75 percentage points when the reduction drops out of the annual comparison in December 2009 and by a further 0.75 points when the 17.5% rate is restored in January 2010. Yet the Report forecasts an increase of just half a point between the fourth quarter of 2009 and the first quarter of 2010. Put differently, tax-adjusted inflation would have to fall to 0-0.5% for the 2010 projections to be met.

Industrial output in the Group of Seven (G7) major economies fell an estimated 12% between February and December last year, based on data for six of the seven countries (Canada has yet to publish for December). This is equal to the peak-to-trough decline during the 1974-75 recession – see first chart.

Business surveys signal a further fall in output in early 2009, implying the current G7 industrial slump will soon be the deepest since World War 2.

For a longer perspective, the second chart shows estimated annual average growth rates of G7 industrial output back to the late nineteenth century. The underlying country statistics were assembled from various sources, including an Economist publication One Hundred Years of Economic Statistics.

If annual average G7 output in 2009 were to equal the December level, it would be 9% lower than in 2008 (red line in chart). This would be the largest annual decline since 1938, when the "Roosevelt recession" in the US led to a 10% drop.

However, the current downturn would have to extend hugely in magnitude and duration to be comparable with the depression of the early 1930s. G7 industrial output plunged for three successive years – 9% in 1930, 13% in 1931 and 10% in 1932.

The third chart shows annual rates of change of G7 output and inflation-adjusted broad and narrow money supply measures. While G7 activity will slide further in early 2009, strengthening real money growth continues to offer hope of an improvement in economic trends later in the year.