Sunday Telegraph columnist Liam Halligan notes that US recessions since the early 1970s have been preceded by a spike in oil prices, defined as a sharp rise of 80% or more. Spot Brent crude has risen from a low of $67.4 per barrel in late May last year to $112.5 on Friday – a 67% gain. The 80% threshold would be reached by a further increase to $121.3. Should investors fear another US – and global – downturn?

A monetarist view is that oil spikes lead to recessions because they raise the general level of prices, thereby deflating real money balances, with monetary contraction in turn causing consumers and firms to cut spending. The extent of the increase necessary to cause a downturn, therefore, depends on 1) the sensitivity of the general price level to changes in oil costs and 2) the rate of monetary growth when the spike occurs.

The impact of a given oil price increase on consumer budgets has fallen since the 1970s. US consumer outlays on energy goods and services accounted for 5.8% of total spending in the fourth quarter of 2010 versus an average of 7.3% over 1971-80. The current share, however, is up from 4.3% in 2002 – the lowest in annual data extending back to 1929.

The chart shows six-month growth in G7 narrow money and consumer prices (both seasonally adjusted). Monetary expansion has accelerated recently, reflecting US strength – see previous post. Real growth has been slowed by a pick-up in inflation but is still running at a solid pace by historical standards. The current relationship is very different from 2000 and 2007, before the last two US and global recessions, when a combination of slower nominal monetary expansion and rising inflation resulted in a contraction in real money.

The current level of oil prices should cause inflation to rise further but is unlikely to push it above the recent rate of money growth. The completion of US QE2, meanwhile, may keep monetary expansion elevated through mid-year, despite weakness in Euroland (previous post). Against this backdrop, oil prices would probably need to rise by significantly more than Mr Halligan's suggested 80% to create a squeeze on real money balances sufficient to trigger another recession.

Put differently, the risk of a recession depends importantly on whether the oil price spike is due to an actual or feared supply shock or also reflects easy money and strong global demand. The current surge seems partly related to monetary loosening – prices broke out to new post-recession highs soon after the Fed embarked on QE2 last November. This suggests that, relative to prior episodes, there will be a larger boost to inflation and a smaller negative impact on economic activity.

Monetary trends continue to suggest deteriorating Eurozone economic prospects.

Narrow money M1 is a better economic leading indicator than the broader M3 measure; it weakened before the last recession and surged before the recovery. M1 comprises currency in circulation and overnight deposits – forms of money more likely to be related to economic transactions. Six-month M1 growth has slumped from 3.6% (not annualised) in August to 0.2% in January. With CPI inflation picking up, real M1 is contracting at a similar pace to early 2008, just before output cratered – see first chart.

This weakness contrasts with a strong pick-up in US real M1 expansion, which predated the start of QE2 in early November – second chart. Together with US fiscal stimulus – particularly the temporary 100% bonus depreciation allowance – this suggests much faster economic growth in the US than Euroland this year, with possible implications for relative equity market performance and the euro-dollar exchange rate. (A similar monetary divergence in 1991 was associated with superior US equity returns, partly due to a stronger dollar.)

Eurozone M3 trends are also soft, with a rise of only 0.5% in the six months to January, again implying real contraction.

M1 weakness was initially focused on peripheral economies but has now extended to the core, including Germany – third chart. Consensus hopes that German economic strength will insulate core economies from a peripheral "double-dip" look increasingly fanciful. ECB hawks may struggle to gain traction against this backdrop.

Today's fourth-quarter GDP revision contains little news but may incline MPC waverers towards waiting for more data on the performance on the economy in early 2011 before voting for a rise in Bank rate.

Last quarter's GDP fall was revised down from 0.5% to 0.6%, mainly reflecting a larger decline in services output, concentrated in business services and finance. The change in gross value added excluding oil and gas extraction, however, remained at -0.5%.

The Office for National Statistics continues to claim that December's bad weather depressed GDP by 0.5% over the quarter, implying that the economy would have contracted by 0.1% in its absence – slightly more pessimistic than its previous interpretation that underlying economic performance was "flattish".

The view here remains that the ONS view is too bearish and that GDP was on course to rise by about 0.25% last quarter before the weather hit:

• A GDP estimate based on monthly output data for industry, services and construction (comprising 99% of GDP) rose by 0.4% in the three months to November from the previous three months – see chart.

• The average level of the monthly estimate in October and November was 0.1% higher than in the third quarter while November business surveys were signalling expansion in December.

• The expenditure measure of GDP, before incorporating ONS consistency adjustments, fell by -0.4% last quarter. The "official" GDP number is based mainly on output-side information at this stage of the estimation process but the expenditure figure may, on this occasion, be more reliable, suggesting underlying GDP growth of 0.1% – higher if the ONS estimate of a 0.5% negative impact from the weather is too low.

Despite the December weather hit, nominal domestic spending grew by 6.2% in the year to the fourth quarter – faster than in the five years before the recession (i.e. during the credit bubble) and above a level consistent with achievement of the 2% inflation target over the medium term.

A reasonable scenario remains that monthly GDP changes over January-March 2011 will mirror those in the three months following the weather-related slump in January 2010. This would imply a 1.1% GDP rise in the first quarter, assuming no further revision to the fourth-quarter estimate.

The February MPC minutes suggest that Bank rate will rise in two weeks' time if revised fourth-quarter GDP figures and purchasing managers' / consumer surveys for February indicate that economic recovery is continuing.

The minutes reveal that Bank of England chief economist Spencer Dale joined Andrew Sentance and Martin Weale in voting for an interest rate hike this month. This is no surprise given his role in preparing the Inflation Report forecast, which signals a need for immediate tightening (see below). Adam Posen maintained his dissent in favour of a £50 billion expansion of QE.

The "MPC-ometer" model forecast a 4-4-1 vote split in February, i.e. four members voting for a quarter-point hike. The actual split was 3-5-1 but Andrew Sentance voted for a half-point move this month, as suggested by his speech last week. The "average interest rate vote", therefore, was exactly in line with the model's prediction.

One feature of the model is that the current month's forecast depends partly on the previous month's vote. The MPC's hawkish shift in February, therefore, has pushed the model further in favour of a quarter-point hike in March although there is still a chance that this prediction will be reversed if February's EU consumer survey (tomorrow), the fourth-quarter GDP revision (Friday) and purchasing managers' surveys for February (next week) are weak.

This assessment is consistent with the minutes, which reveal that, of the middle group on the MPC, "some thought that the case for an increase had ... grown in strength" but "there was merit in waiting to see how indicators of how the economy performed at the start of the year to help assess whether or not the decline in GDP in the fourth quarter presaged sustained economic weakness".

The waverers could also use current geopolitical unrest as an excuse for delaying action.

The numerical Inflation Report forecasts released today, however, create a strong presumption in favour of an immediate increase. Confirming an initial reading last week, the mean forecast for inflation in two years' time based on unchanged policy is 2.48%, representing the largest overshoot of the target since February 1998, when official rates were rising sharply (by more than 150 basis points over 14 months).

A post last August suggested that public sector net borrowing excluding the temporary effects of financial interventions (i.e. PSNBex) would undershoot the Office for Budget Reponsibility's £149 billion projection for 2010-11 by a significant margin, calling into question the necessity of the VAT rise to 20%. This forecast is back on track following favourable January numbers, released today.

PSNBex fell to -£3.7 billion (i.e. a surplus) in January versus £1.3 billion a year earlier. Borrowing in the prior nine months of 2010-11, moreover, was revised down by £1.6 billion.

If seasonally-adjusted borrowing (see chart) is stable at its January level in February and March, the full-year deficit will be £139 billion versus £156 billion in 2009-10.

The large year-on-year improvement was driven by a £6.4 billion rise in central government current receipts, mainly reflecting higher income and corporation taxes, with increased VAT contributing only £700 million. Current receipts are up 8.4% year-to-date versus the OBR's full-year forecast of 7.1%, suggesting that underlying economic growth is running ahead of its expectations.

In the June Budget, the VAT rise to 20% was projected to raise £2.8 billion in 2010-11 and £12.1 billion in 2011-12. Excluding its impact, PSNBex is on course for a £7 billion undershoot of the OBR's June projection in 2010-11. Assuming that this carries over to 2011-12, the June borrowing path could have been achieved by calibrating the VAT change to raise about £5 billion rather than £12.1 billion, suggesting a rise to 18.5% rather than 20%.

The chart updates a comparison of the rise in the Dow Industrials index from its low in March 2009 with six prior increases following bear markets involving a fall of about 50%. (The six bears bottomed in November 1903, November 1907, December 1914, August 1921, April 1942 and December 1974. The Dow fell by 45-52% into these lows versus a 54% decline between October 2007 and March 2009.)

From its 2009 low until April 2010, the Dow mostly traded above a "six-bear average" of the prior recovery paths. This probably reflected unusually loose monetary conditions due the Federal Reserve's QE1 securities purchases, totalling $1.725 trillion.

Following the end of QE1 in March 2010, the Dow traded back to and then below the six-bear average. By early July, the index was 10% beneath the average and within 1% of the bottom of the range spanned by the prior recoveries. This suggested a buying opportunity.

The Dow built a base over the summer and took off in September as the Fed signalled QE2, following through with the announcement of a $600 billion securities purchase plan in early November. This liquidity injection, supplemented recently by a rundown of the Treasury's supplementary financing program (SFP), has pushed the index 11% above the six-bear average – a larger deviation than at the July low.

The Dow is now higher than at the equivalent stage of five of the six prior recoveries. All five of these predecessors suggest a significant fall by year-end, ranging from 10% to 31% from Friday's close of 12391 (i.e. to between 8500 and 11200).

There is, however, one exception – the rise from the low in November 1903. At the comparable stage of that increase (i.e. in November 2005), the Dow embarked on a 23% surge over 11 weeks to a level equivalent to 16000 currently.

History, therefore, suggests a five-sixths probability of a decline in the Dow but a one-sixth chance of a "moonshot" scenario, involving a final blow-off and subsequent sharp correction.

The Dow's surge over November 1905-January 1906 occurred after it had breached its previous all-time high, reached in June 1901. The move into new ground may have stimulated buying. Currently, the Dow is still 13% below its October 2007 peak but smaller stocks are close to breaking out – the Russell 2000 index is within 3% of its high. US investors are showing more interest in domestic equities, channelling $12 billion into US-focused stock mutual funds so far this year, according to the Investment Company Institute, following an outflow of $88 billion in 2010.

The "moonshot" scenario could, perhaps, be triggered by the further $450 billion rise in bank reserves implied by the Fed completing QE2 and the SFP falling to $5 billion as planned – see Friday's post.

Equity investors face a dilemma: the odds favour market weakness but there is an outside chance of a blow-off that would cause a defensively-positioned portfolio to underperform significantly. Any such surge, however, would probably end badly: the January 1906 peak marked the start of another major decline, of 49%, to a low in November 1907.