Detailed monetary statistics for December contain some glimmers of hope, suggesting the recession will hit bottom by the third quarter of 2009. In contrast to the US, however, UK monetary trends are not yet consistent with an economic recovery, in the sense of a return to trend growth or higher.

Annual rates of change of inflation-adjusted broad and narrow money have recovered from their October low, reaching the highest level since May – see first chart. This reflects slowing retail prices rather than much change in nominal money trends but is nonetheless meaningful – real money typically leads the economy by about six months. A further plunge in RPI inflation should sustain the revival in early 2009 but real growth rates would need to rise to 5-10% to signal an economic recovery.

A further positive development was a 1.8% monthly rise in broad money holdings of private non-financial corporations – the first increase since July and the largest since April 2007. The corporate liquidity ratio – money holdings divided by bank borrowing – could be bottoming, in contrast to a continued slide in the Eurozone – second chart. However, it remains very low by historical standards and usually surges ahead of recoveries.

Rises in net mortgage lending (from £830 million in November to £1.9 billion in December) and the number of mortgage approvals (from 27,000 to 31,000) are small and should be treated with caution. The increase in lending is explained by a fall in repayments – gross advances continued to slide to a seven-year low – while approvals were still down 58% from a year before.

In other news today, Japan’s industrial output plunged by 9.6% in December and – even more shockingly – manufacturers plan to slash production by a further 13% in January and February, according to a survey by the Ministry of Economy, Trade and Industry. Based on December data for the US and Japan and November numbers for other countries, G7 industrial output is now an estimated 10-11% below its February 2008 peak. With further weakness highly likely, the cumulative fall should soon challenge the 12% peak-to-trough decline in the brutal 1974-75 global recession – third chart.

The IMF’s new forecasts show UK GDP declining by 2.8% in 2009 versus an average fall in advanced economies of 2.0%. The UK’s performance is projected to be the worst of the Group of Seven (G7) major economies.

This forecast, however, is more a reflection of recent developments than a view that the UK will underperform going forward. UK GDP and output figures published last week imply that monthly GDP in December was 1.0% below the fourth-quarter level and 2.4% lower than the calendar 2008 average – see here. So the IMF forecast for 2009 implies a further decline in GDP from December of only 0.4%.

The UK is the only G7 country yet to have published fourth-quarter GDP numbers. Performance in other major nations is likely to be similarly dire or even worse, in which case IMF projections may need to be revised down.

After the UK, Japan and Germany are forecast to suffer the largest GDP declines in 2009, of 2.6% and 2.5% respectively, reflecting their exposure to collapsing world trade. Countries that “fixed the roof” in good times – running savings surpluses and avoiding domestic credit / housing booms – are suffering at least as much as deficit offenders in the current global downturn.

The Bank of England has estimated that the five largest UK banks and Nationwide would sustain aggregate credit losses over five years of £115-130 billion in a “severe but plausible macroeconomic risk scenario” (see the October Financial Stability Report, pp.28-9). As explained below, an examination of credit impairment suffered by major high-street banks in the aftermath of the recessions of the early 1980s and early 1990s suggests a larger five-year loss, of £190-240 billion. Even this amount, however, could be absorbed by existing capital resources and future profits, implying additional government financial support may be unnecessary.

Credit losses suffered by British banks in the 1980s reflected both a severe domestic recession at the start of the decade and the Latin American debt crisis, initiated by Mexico’s default in 1982. Banks had stepped up their lending to developing-country governments in the late 1970s as they sought to recycle surplus oil funds – comparable perhaps with their recent disastrous foray into US subprime mortgages.

International losses were less important in the early 1990s but domestic default experience was worse than in the 1980s, despite a less serious recession, probably because of punishingly high real interest rates necessitated by sterling’s membership, until September 1992, of the exchange rate mechanism. By contrast, current low nominal and real interest rates will enable some default-prone borrowers to continue to service their loans.

On this basis, it is defensible to assume that current credit losses will be similar to but no greater than those suffered in the 1980s and 1990s downturns. One difference from these earlier episodes is that a much greater portion of banks’ credit exposure now resides in their securities portfolios rather than the traditional loan book. So it is appropriate to compare loan losses in the earlier recessions with total losses – both loan impairments and writedowns of securities – in the current cycle.

The chart shows high-street banks’ annual “impairment and other provisions (net)”, as reported by the British Bankers’ Association (BBA), expressed as percentage of their “assets at risk”, defined here as total assets minus cash held at the Bank of England, UK interbank lending and advances under sale and repurchase agreements. Two series are plotted, including and excluding “problem-country debt” (PCD) provisions. (The PCD figures were sourced from Bank of England Working Paper no. 177 The provisioning experience of the major UK banks: a small panel investigation by Darren Pain.)

In the five years from 1982 to 1986, provisions as a percentage of assets at risk totalled 4.7%. However, this understates credit impairment over the period because banks delayed taking charges for problem-country debt until 1987 and 1989. If these PCD charges are included, the 1982-86 total rises to 8.9%.

Provisions were made on a more timely basis in the early 1990s downturn and totalled 7.1% of assets at risk over 1989-93.

Based on 2008 assets at risk of £2.7 trillion, the five-year provision rates of 7.1% in the 1990s and 8.9% in the 1980s would imply aggregate credit losses for the major high-street banks of £190 billion and £240 billion respectively over 2008-12.

Such numbers are considerably larger than the Bank of England’s October estimate of £115-130 billion but this does not imply that banks require additional government financial support, for the following reasons:

1. Banks raised over £70 billion of new capital during 2008 to cover credit impairment, including £37 billion from the government.
2. The Financial Services Authority last week stated it would allow tier 1 ratios to fall to 6-7% as credit losses materialise. The average tier 1 ratio of major banks rose to more than 11% after last year’s capital-raising, implying a buffer of about £100 billion.
3. High-street banks’ net income before provisions and tax averaged £35 billion pa over 2003-07, according to the BBA. Assuming a similar run-rate before losses over 2008-12, about £175 billion will be available to shore up balance sheets and / or pay dividends. (Tax payments will be modest given credit losses.)
4. Banks’ net interest income fell to a record low 0.8% of assets in 2007, according to the BBA, versus an average of 1.3% over the previous five years. If the interest margin were restored to 1.3%, pre-tax profits would rise by about £25 billion pa or £125 billion over five years.

On reasonable assumptions, therefore, £400 billion of capital reserves and future profits could be available to set against credit losses of £190-240 billion over 2008-12. This would be sufficient to allow banks to expand their lending and even resume normal dividend distributions. Such a scenario, however, depends on the authorities affording them the flexibility to absorb losses over time, as in previous cycles. The alternative of requiring up-front accounting for future losses and further capital-raising on expensive terms is neither necessary nor desirable.

All measures of the US money supply have risen strongly over the last three months – see chart and text below for definitions. On the traditional monetarist view that money leads the economic cycle by about six months, this suggests US activity will stabilise and begin to recover from the second quarter.

The Federal Reserve embarked on “quantitative easing” – i.e. monetary base expansion – in September. However, the broadest money measure M2+ began to accelerate only after the Fed began to buy commercial paper in late October. In contrast to its prior operations, which relied on banks transmitting additional liquidity to the wider economy, this initiative injected cash directly into corporate bank accounts.

Commercial paper purchases have slowed recently but the Fed has started to implement a previously-announced plan to buy up to $500 billion of agency mortgage-backed securities (MBS). External investment managers acting for the Fed had acquired $53 billion of MBS by last Wednesday. To the extent that purchases are from non-bank investors, this operation will also have a direct positive impact on broad money. The Fed is likely to discuss further initiatives, such as purchases of Treasuries, at this week’s policy meeting.

Sceptics argue that monetarist optimism is misplaced because faster money growth is being offset by a decline in the velocity of circulation. Clearly, recorded velocity is falling but this reflects the lag between money supply changes and their impact on activity and prices and is not evidence that the Fed’s new policy will be unsuccessful. Monetary trends are a leading indicator of nominal GDP whereas velocity is, at best, coincident.

Definitions:
M1 = currency and checkable deposits
M2 = M1 plus savings deposits, small time deposits and retail money funds
MZM = money of zero maturity = M1 plus savings deposits and all money funds
M2+ = M2 plus large time deposits at banks and institutional money funds (my definition and calculation)
Note: M3 = M2+ plus repurchase agreements and Eurodollar deposits (no longer published)

The shocking 1.5% GDP fall in the fourth quarter reflects a collapse in output in November and December. The chart shows quarterly GDP rebased to the peak in the second quarter of 2008 together with a monthly estimate derived from data on industrial and services production. Monthly GDP was little changed between September and October but plunged 1.7% in November and a further 0.7% in December. (The Office for National Statistics currently has little information on activity in December so the latter figure could be revised significantly.) The December reading was 1.0% below the fourth-quarter average, implying a large negative carry-over into the first quarter. Monthly GDP has fallen 3.6% from a peak reached in April last year.

Retail sales figures also released today show a 0.6% rise between the third and fourth quarters. With retail spending accounting for about 20% of GDP, this suggests that other components of demand – non-retail consumer spending, government consumption, investment, stockbuilding and net exports – subtracted 1.6 percentage points from economy-wide output in the fourth quarter. In other words, GDP excluding high-street spending fell about 2%.

The severe corporate liquidity squeeze is likely to have resulted in a major decline in business investment and stockbuilding. Housing investment and consumer spending on cars should also have made significant negative contributions while even government expenditure may have fallen – output of “government and other services” was down 0.5% from the third quarter. Trade figures for October and November suggest net exports of goods had little impact, despite sterling’s plunge.

As previously noted, monetary weakness in late 2008 implies continuing economic contraction during the first half but prospects for later in the year will depend on money and credit trends in early 2009. Fed-style operations to bypass the banking system and supply cash and credit directly to companies, financial institutions and households offer the best hope of avoiding a prolonged recession. The new Bank of England asset purchase facility is a promising first step – the MPC should push for rapid implementation and expansion of the programme.

UK labour demand is weakening rapidly, as evidenced by data released yesterday showing a 26% slump in the stock of job vacancies between March and December 2008.

The recent pace of decline is faster than during the recession of the early 1990s but less rapid than over 1974-76 and 1979-81 – see chart. In other words, while confirming a serious employment recession, vacancies have yet to indicate a downturn on the scale of the mid 1970s or early 1980s.

In the three prior recessions, the stock of vacancies reached a trough 18-24 months after peaking having fallen between 52% and 69%. This suggests a further decline of 35-58% from the December level, with a bottom between September 2009 and March 2010.