Recent monetary developments have been worrying, with underlying M4 growth (i.e. excluding money holdings of certain financial intermediaries) slowing sharply and the corporate liquidity ratio falling to a 17-year low. However, some comfort can be drawn from stable household sector money trends.

The chart shows annual growth rates of consumer spending and two measures of household real money – overall M4 and non-interest-bearing M1 (i.e. currency holdings plus interest-free sight deposits). The consumer recessions of the mid 1970s, early 1980s and early 1990s were associated with annual falls in one or other measure. However, both are still growing solidly currently.

This resilience may not persist but household money trends are not yet consistent with a sustained contraction in consumer spending.

The inflation surge of the 1970s is widely acknowledged to have been caused partly by insufficiently restrictive monetary policies following the 1973 oil “shock”. Are policy-makers similarly at risk of “accommodating” the inflationary impact of higher commodity prices now, as they simultaneously seek to minimise economic weakness caused by credit market woes?

The rise in oil prices in recent years has occurred in two distinct stages, which mirror the two shocks of the 1970s, although the primary driver has been emerging world demand for energy rather than supply disruption. The initial breakout from the range of the prior decade occurred between late 2003 and mid 2005, when prices rose from $35 to $65 a barrel (expressed in terms of today’s US consumer price level). A period of stability then ensued until early 2007, when prices embarked on a further surge to their recent peak above $140. For comparison, inflation-adjusted prices rose from $13 to $45 during the 1973 oil shock (caused by an Arab embargo on supplies to allies of Israel) and from $45 to a peak above $110 in 1978-79 (as the overthrow of the Shah led to sharp fall in Iranian exports).

A simple way of measuring the monetary policy response to an oil price change is to compare subsequent movements of short-term interest rates and headline consumer price inflation. As the chart below shows, average G7 short rates failed to keep pace with inflation following the 1973 shock – real rates were consistently negative over 1974-78. This policy response is now recognised to have been misguided: it allowed higher inflation expectations to become entrenched and did not avert a severe recession. By contrast, short rates were raised well above the level of inflation after the second shock of 1978-79, partly under the influence of hawkish US Fed Chairman Paul Volcker. Recession again ensued but the restoration of monetary discipline laid the foundations for a sustained decline in inflation during the 1980s.

How does recent experience compare with these episodes? The 2003-05 oil price rise was less dramatic than the 1973 shock and had a much smaller impact on headline inflation. As the chart shows, G7 short rates moved up in line during the shock and became significantly positive in real terms in 2006 as inflation fell back. On this basis, policy appears to have been broadly appropriate, although the Fed should arguably have been swifter to tighten in 2004-05 – low real rates contributed to the subsequent housing market bubble. The response to the more recent oil price surge has been less convincing. The Fed’s decision to prioritise credit market concerns and ease policy aggressively coupled with a larger rise in headline inflation than in 2003-05 has resulted in G7 real short rates becoming significantly negative. As in the mid 1970s, it is debatable whether policy laxity has served the intended purpose of supporting activity and it may have contributed to an unwelcome rise in inflation expectations.

It is possible to argue that G7 monetary policies are tighter than suggested by the level of real short rates because of the impact of the credit crisis on banks’ lending behaviour. However, the interest rate measure used in the chart is based on interbank rather than policy rates so partly incorporates current market dislocation. Moreover, any assessment of the global monetary stance must also include emerging economies, where banks are generally still lending freely and short rates are even further below inflation. Taking these considerations into account, there appears to be little scope for any early decline in global rates if inflation is to be returned to the low levels of the last decade. Indeed, a rise may be required – led by the US and emerging economies where real rates are heavily negative – to ensure sufficient monetary discipline.

M4 and M4 lending jumped sharply in June but the increases were largely due to “other financial corporations” (OFCs) and may reflect distortions caused by the Bank of England’s special liquidity scheme. Excluding OFCs, M4 rose by 6.4% in the year to June, the lowest annual growth rate since 2000 – see first chart.

Corporate liquidity trends are particularly concerning: M4 holdings of private non-financial corporations (PNFCs) fell for the fourth consecutive month, while their liquidity ratio (cash divided by bank borrowing) slumped to a new 17-year low, with negative implications for future business spending – see second chart.

This is not a time for hawkish heroics. The MPC should hold rates at next week’s meeting and be prepared to ease later in the year if these money trends continue.

Contrary to consensus expectations, the US has held up better than other major economies since the credit crisis erupted last summer.

The first estimate of US second-quarter GDP is released on Thursday. According to Reuters, economists expect quarterly growth of 2.0% annualised (I think a stronger number is likely). If realised, this would imply a year-on-year increase of 2.1%.

Available evidence suggests the Eurozone and Japanese economies contracted in the second quarter, partly as pay-back for exaggerated strength in the first three months. Assume optimistically that GDP is unchanged on the quarter in both cases. This would imply year-on-year growth of 1.7% and 2.0% respectively.

UK second-quarter numbers released on Friday showed year-on-year GDP growth of just 1.6%.

Stopped-clock pessimists now expect a US recession to start during the second half. They will be right one day but I expect the economy to stay afloat, based on loose policies and low inventories – likely to have fallen further in the second quarter. Downside risks look much greater in Europe.

Since the credit crisis erupted commentators have frequently speculated that the Bank of England has advanced funds outside the framework of its normal money market operations to banks other than Northern Rock. There is no evidence from available sources of any sterling lending of this sort. However, the recently published Bank of England Annual Report shows that the Bank substantially increased its foreign currency lending to banks during its last financial year.

According to the Report, “loans and advances to banks” by the Bank’s Banking Department rose by £32.2 billion between 28 February 2007 and 29 February 2008 (from £31.6 billion to £63.7 billion – see note 10 on page 66). The weekly Bank Return indicates that the Banking Department’s money market operation loans (“sterling reverse repos”) were little changed between the two dates, while the Report also states that lending to Northern Rock stood at £24.3 billion on 29 February 2008 (note 29, section a) on pages 82-83). This leaves an “unexplained” increase in lending of about £8 billion.

Section d) of note 31 on pages 88-90 confirms that this represents foreign currency lending. Non-sterling “loans and advances to banks” increased by £8.2 billion over the year (from £10.8 billion to £19.0 billion). This was financed by an £8.5 billion increase in foreign currency deposits from other central banks (from £7.0 billion to £15.4 billion).

To a small extent, these rises reflect the currency translation effect of a weaker exchange rate. However, even if all the non-sterling loans were denominated in euros, this would account for only £1.4 billion of the £8.2 billion increase in foreign currency loans.

The “innocent” explanation for this lending is that foreign central banks asked the Bank of England to place foreign currency funds in the market on their behalf. However, it seems an unlikely coincidence that such a large rise occurred during a year when the banking system was under considerable stress.

More probably, the Bank borrowed under arrangements with one or more other central banks to onlend to banks in London facing difficulties raising foreign currency funds in wholesale markets. Such an operation would be similar to the currency swap between the Federal Reserve and the ECB and Swiss National Bank introduced last December and increased in size in March and May, under which the Fed advanced funds to be auctioned off to dollar-short banks in Europe.

Perhaps there is another explanation but this one fits the facts. It seemed strange at the time that the Bank of England was not involved in the announced Fed currency swap facilities. It may have chosen a more “covert” form of lending to avoid drawing further attention to UK banks’ difficulties after the Northern Rock debacle.

Key themes in my outlook for 2008 were 1) global economic resilience despite the credit crisis, 2) US outperformance of Europe and 3) inflationary risks stemming from the Fed’s excessive policy easing.

These themes receive support from the IMF’s latest global economic forecasts, published last week.

The IMF now believes world GDP will rise by 4.1% in 2008, up from 3.7% in April. 4.1% is a respectable number by historical standards – growth averaged just 2.9% over 1990-99.

Among the major economies, the US has received the largest upgrade – growth is now forecast at 1.3% in 2008, up from just 0.5% in April. This could still be too low, with second-quarter figures next week likely to show annualised growth of 3% or more.

Meanwhile, average 2008 consumer price inflation has been revised up by 0.8% and 1.7% in advanced and emerging economies, to 3.4% and 9.1% respectively.

Looking forward, relatively loose monetary policies and solid emerging world momentum should continue to limit global economic weakness. Downside risks stem less from the credit crisis than an inflation-induced squeeze on real incomes.

A key issue is whether US and emerging world resilience is offset by gathering weakness in Europe. Today’s flash PMIs for July show the Eurozone economy was slowing sharply as the second half began – see chart.