Some analysts are wrongly claiming that the Bank of England’s asset purchase facility will have no monetary impact. For example, an article in Friday’s Financial Times stated that “the money used to buy the corporate securities will be financed by Treasury sales of government bills rather than the creation of money”.

The simultaneous sale of Treasury bills will ensure no effect on banks’ reserves held at the Bank of England and hence the monetary base M0, implying the scheme does not represent “quantitative easing” in the Japanese sense. Providing Treasury bills are sold to banks, however, while the Bank purchases assets from non-banks, the broad money supply will expand. Banks should indeed absorb much of the increase in the supply of bills, given regulatory pressure to raise their holdings of safe liquid assets.

The potential for the scheme to boost M4 directly is more important than whether it expands the monetary base. M0 growth has already risen significantly as a result of increased Bank of England lending to the banking system, without any noticeable impact on broad money or credit conditions. In the US, wider money measures have accelerated since the Federal Reserve began buying commercial paper and agency securities, having shown little response to earlier initiatives inflating the monetary base.

Another article in the same FT edition claims that quantitative easing can begin only after interest rates have been cut to zero; otherwise “the overnight interest rate in money markets would in any case fall towards zero because commercial banks would find themselves awash with unwanted cash looking for a home overnight”. This is incorrect. Banks are able to deposit excess funds in unlimited amounts at the Bank of England’s operational standing deposit facility, earning interest at Bank rate minus 25 basis points, a level that sets an effective floor for overnight rates.

With the option of underfunding the budget deficit apparently still off the policy agenda, the asset purchase facility represents the best hope for an early and significant revival in broad money growth. Rapidly implemented and suitably expanded, the scheme could lay the foundations for an economic recovery from late 2009.

The tier 1 capital ratios of major British banks would fall below the 6-7% minimum required by the Financial Services Authority if they were forced to write down the value of their mortgage portfolios in line with the market prices of mortgage-backed securities used by the Bank of England in its operation of the special liquidity scheme (SLS). However, actual losses are likely to be a fraction of those implied by these prices, illustrating the absurdity of mark-to-market assessments of capital adequacy.

When the SLS closed on 30 January, the Bank of England held securities with a nominal value of £287 billion as collateral against Treasury bills lent under the scheme. The Bank’s valuation of these securities was £242 billion, implying a discount to par of about 16%. The collateral was mostly in the form of AAA-rated residential mortgage-backed securities and covered bonds. Since AAA tranches suffer impairment only after lower-rated tranches have been wiped out, a 16% discount suggests a much larger expected loss – of perhaps 25% – on the underlying pool of mortgages.

Major banks held £496 billion of residential mortgages on their balance sheets at the end of 2008, according to the British Bankers’ Association. Ignoring additional exposure via off-balance-sheet entities, a write-down of 25% would reduce capital by about £125 billion – sufficient to cut banks’ current aggregate tier 1 ratio of over 11% by more than half.

The chances of actual losses on this scale are miniscule. In the worst year of the early 1990s housing downturn – 1991 – 0.77% of mortgaged properties were repossessed, according to the Council of Mortgage Lenders. Even assuming a repossession rate of 0.77% sustained for 25 years, and a loss given default of 50%, the cumulative reduction in the value of mortgage principal would be less than 10%.

The large deviation of market prices of mortgage-related securities from their likely economic value reflects extreme investor risk aversion and illiquidity. There is a strong case for the Bank of England to use its new asset purchase facility to buy such securities, in addition to corporate bonds and commercial paper. Targeting a wide range of assets would facilitate an early expansion of the facility – necessary if it is to have a meaningful impact on monetary growth.

Sharp falls in annual consumer and retail price inflation in December have prompted claims that the economy stands on the brink of deflation, justifying today’s further reduction in Bank rate to 1.0%. The declines, however, are entirely explained by the 2.5 percentage point cut in VAT, falling energy costs and – in the case of the RPI – lower interest rates. Underlying inflation has yet to show much response to economic weakness.

Annual CPI inflation fell from 4.1% in November to 3.1% in December. Since its first statistical release a fortnight ago, the Office for National Statistics (ONS) has published a December number for the “CPI at constant tax rates” (CPI-CT), i.e. adjusted for the impact of the VAT cut. This incorporates official estimates of the extent to which the reduction was passed on by retailers and other consumer suppliers. Annual CPI-CT inflation actually rose in December, from 3.9% to 4.1% – see chart.

The annual increase in the CPI’s energy component moved lower in December, from 16.7% to 12.2%, mainly reflecting falling petrol prices. If the rate of change had remained at 16.7%, annual CPI-CT inflation would have risen further, to an estimated 4.3%.

To gauge underlying pressures, it is helpful to exclude both energy prices and the effect of the VAT reduction. The annual increase in the CPI excluding energy eased from 3.1% to 2.3% in December. Without the VAT cut, however, the December number would have risen to an estimated 3.4% – equal to the peak reached in August / September.

Annual RPI inflation dropped from 3.0% in November to just 0.9% in December. The ONS does not publish an RPI series at constant tax rates but RPIY – which excludes indirect taxes and mortgage interest costs – rose an annual 3.9% in December, unchanged from November.

The severe recession will rapidly reduce domestic inflationary pressures but the slump in sterling is having an offsetting impact, with manufactured import prices rising by an annual 14% in November (December figures are due next week). Energy price effects will ensure a further significant drop in headline CPI and RPI rates during 2009 but the decline is likely to be smaller than the MPC and consensus expect, while VAT-adjusted non-energy inflation may remain above 2%.

My MPC-ometer projects a further half-point cut in Bank rate to 1.0% tomorrow. This is also the expectation of 61 out of 68 economists, according to a Reuters survey. The model’s forecast is heavily influenced by the 1.5% slump in GDP in the fourth quarter reported a fortnight ago. Further falls in consumer confidence and manufacturing pricing plans and January’s weak stock market performance are also contributory factors.

In my view, another cut in rates is less important than measures to boost underlying broad money growth, which remains too low to support an economic recovery – see here. Improving credit availability is clearly also a priority but credit constraints would be relieved by an increase in the quantity of money circulating in the economy.

The simplest way to boost broad money would be to “underfund” the huge budget deficit, i.e. finance it by borrowing from banks or the Bank of England rather than by issuing gilts. This would not imply a reduction in banks’ capacity to lend to firms and households, because institutions are not required to set aside additional capital against increased lending to the government. Underfunding is a conventional unconventional measure, to use Bank of England Governor Mervyn King’s terminology. It occurred after the early 1990s recession, helping to underpin an economic recovery, and again in 2001-02, when the UK managed to skirt a global downturn.

An alternative to underfunding would be for the Bank of England to use its asset purchase facility to buy securities from non-bank financial institutions and companies. Such purchases would directly boost broad money; by contrast, buying assets from banks has a positive impact only if they respond by increasing lending. The Bank could, for example, buy newly-issued commercial paper or longer-maturity asset-backed securities (more likely to be held outside the banking system).

Whether such transactions boost the monetary base (i.e. currency in circulation and banks’ deposits at the central bank) – thereby qualifying as “quantitative easing” – is of secondary importance. Banks’ unwillingness to lend reflects capital constraints and risk aversion rather than a shortage of cash. Monetary base growth has already picked up significantly as a result of the Bank of England’s expanded lending to the banking system, without any noticeable impact on the broad money supply or credit availability – see chart.

A further interest rate cut could be counterproductive in terms of improving credit availability. Banks need to be able to widen interest margins in order to rebuild capital to support higher lending. As the general level of interest rates approaches zero, however, their ability to lower deposit rates is constrained by increasing competition from government-guaranteed savings products offering full security with little or no loss of income. Forced to lower lending rates to existing borrowers on deals linked to Bank rate or LIBOR, banks may compensate by raising rates charged on new loans.

The Bank of England yesterday reported that banks and building societies had borrowed £185 billion of Treasury bills under the special liquidity scheme (SLS) by the time of its closure on 30 January – broadly consistent with my earlier estimates (e.g. here). The SLS has been superseded by the Bank’s new discount window facility (DWF). Drawings from the DWF will be published quarterly but with a considerable lag – first-quarter figures will be available at the end of June.

The net percentages of senior bank loan officers reporting tighter credit standards on loans to businesses and residential mortgages declined between October and January, according to the Federal Reserve’s latest survey – see first chart. However, the balances remain above the peaks reached in the 1990-91 and 2001 recessions.

The second chart shows the annual rate of change of industrial output and an average of the net percentages of loan officers reporting tighter standards on loans to large / medium and small firms, plotted inverted. Turning points in the latter series lead the industrial cycle. The latest small change is consistent with an approaching trough in the annual rate of decline of output, confirming the message from real money trends – see here.

British-owned banks are being unfairly blamed for a contraction of sterling banking activity by foreign-owned institutions operating in the UK.

Total sterling assets of UK-based banks grew by 8% in the year to December, down from 14% in the prior 12 months, according to Bank of England data. The 8% rise, however, conceals a 15% increase for domestically-owned banks offset by a 3% contraction in sterling assets of foreign institutions, which account for 34% of the amount outstanding.

Foreign banks continued to expand their lending to the non-bank private sector last year, though at a slower pace than British-owned banks. The decline in their total sterling assets reflected a cut-back in lending to other UK banks – this in turn constrained the ability of British banks to extend new credit to households and firms.

Of the 34% foreign share of total sterling assets, “other EU” banks account for 22 percentage points, “other developed countries” 7 pp and the US 4 pp. Last year’s contraction was due to a large fall in assets of banks from “other developed countries”, a category including Swiss, Canadian and Australian institutions, among others. Sterling assets of “other EU” banks grew by 7% during 2008, partly reflecting Santander’s acquisition – via Abbey – of Bradford & Bingley's savings business. Icelandic banks are also included under “other EU” – their liquidation could affect future data.