Critics of the banks accuse them of boosting margins by failing to pass on Bank rate cuts to borrowers. The banks' last trading statements, however, complain of downward pressure on net interest income. Who is right?

The chart below shows estimates of average interest rates charged on M4 lending and paid on M4 deposits, derived from disaggregated Bank of England data. (The M4 data cover banks' and building societies' sterling business with UK households and corporations.) The difference between the average lending and deposit rates is a measure of banks' net interest margin.

The critics are factually correct to complain of a measly decline in lending rates. Between November 2007 and April 2009 Bank rate was cut by 525 basis points but the average interest rate on M4 lending fell by only 310 basis points. This implies much lower pass-through than during the last big easing of monetary policy, in 2001-03, when Bank rate fell by 250 basis points and the M4 lending rate by 220 basis points.

The benefit to banks of a higher margin on lending, however, has been entirely offset by the disappearance of their deposit margin. In November 2007, the average interest rate on M4 deposits stood at 4.6%, 115 basis points below Bank rate of 5.75%. By April 2009, it was 110 basis points higher – 1.6% versus 0.5%.

In other words, the M4 deposit rate fell by only 300 basis points between November 2007 and April 2009 – slightly less than the average lending rate. Far from bolstering their profits at the expense of hard-pressed borrowers, banks have actually suffered a further decline in their net interest margin over this period – see chart.

Why has the average deposit rate proved so sticky? Clearly the maximum possible fall would have been 460 basis points – its level in November 2007. In practice, banks have been forced to continue to offer interest on sight (i.e. instant access) deposits in order to retain funds – not least because of competition from state-run savings. Meanwhile, the unforeseen collapse in Bank rate has left them temporarily saddled with high term funding costs: the average interest rate on household bank time deposits was still 4.6% in April 2009.

As term funding matures and is refinanced at lower rates, banks should be able to reduce the M4 deposit rate towards Bank rate. Coupled with higher margins on new lending, this should allow a significant recovery in the lending / deposit rate spread. As the chart shows, the spread is currently at an historical low – even a 100 basis point rise would simply return it to the average over 1999-2005, before the recent credit bubble.

Banks are already being accused of profiteering despite a further squeeze in their net interest margin; imagine the furore if they succeed in boosting their profitability. Such a development, however, is needed to speed capital rebuilding and support future lending growth. Moreover, restoration of the margin to a normal level is the mirror-image of an appropriate repricing of credit risk – spread compression in 2006-07 contributed to the lending bubble.

Is the US labour market improving, or at least deteriorating less rapidly? Employees on non-farm payrolls dropped by 345,000 in May – lower than expected and down from an average of 612,000 over the prior three months. An alternative payrolls measure derived from the household survey, however, fell by 833,000, contributing to a further rise in the unemployment rate to 9.4%, a 26-year high.

The jury is out but two other indicators support the more hopeful message from the "official" payrolls series. First, a smoothed measure of employment taxes withheld at source (equivalent to UK PAYE) has edged higher since February – see first chart. Unsurprisingly, withheld taxes are a good coincident indicator of labour incomes and successfully delineated the last recession. (The numbers have been adjusted to take account of a cut in the withheld tax rate from April.)

Secondly, the outplacement firm Challenger, Gray & Christmas Inc's monthly tally of job-cut announcements has fallen steadily from a peak of 234,000 (seasonally adjusted) in January, reaching 111,000 in May – the lowest since September. The series correlates with weekly initial unemployment claims and suggests that claims will extend their recent small decline – second chart. This, in turn, would be consistent with an imminent peak in the unemployment rate.

An earlier post made a case for comparing the recent decline in US share prices with the bear markets of 1906-07, 1919-21 and 1973-74. Like the 2007-09 bear, the falls in 1919-21 and 1973-74 occurred at or near the end of 30-year economic cycles. Meanwhile, the 1906-07 decline was associated with a financial panic with similar characteristics to the Lehman crisis.

The three earlier declines bear a close resemblance, with the Dow Industrials index falling by 45-49% over 22-23 months. The subsequent recoveries also look similar – three years after the start of its decline, the Dow had rallied to stand 17%, 17% and 13% respectively below its peak level.

The earlier post included a chart overlaying the 2007-09 decline on the three earlier bear markets and recoveries. This approach has been taken further in the chart below, which shows a "three-bear average" of the prior episodes. This average provides a template for comparison with current developments; it may also offer guidance on share price prospects.

The Dow peaked in October 2007 and followed the three-bear average closely until September last year, when the Lehman crisis led to a dramatic lurch down. The deviation widened in early 2009 as fears of banking system nationalisation exacerbated weakness. The rally since March, however, has closed the gap and the current level of the Dow is now only marginally below the template.

The average declines further over the summer, reaching a low about 10% below yesterday's Dow close at the start of September. It then embarks on a sustained rise, climbing 25% from the September low by the end of 2009 and a further 27% during 2010.

Historical comparisons should be treated with caution but the shape of this "forecast" appears plausible. The recent rally has been driven by a reallocation of cash to equities by investors who had been underweight; a period of consolidation may be necessary before a further advance based on a recovery in corporate earnings – conditional, of course, on the global economy returning to growth later in 2009.

The MPC-ometer is designed to predict the outcome of each month's MPC meeting based on incoming economic news and financial market developments. It forecasts no change in either Bank rate or quantitative easing plans at today's meeting.

The balance of news over the last month is judged to be neutral. Growth and financial market indicators have improved: business surveys are stronger, the stock market has rallied further and interbank interest rates have fallen. Inflation indicators, however, have weakened, with the headline CPI increase slowing sharply and first-quarter average earnings down by 0.1% from a year earlier.

The MPC last month expanded its quantitative easing programme to £125 billion, implying that Bank of England asset purchases will continue until the end of July. QE is intended to boost money supply growth. The latest monetary statistics suggest that the policy is working. A decision about a further extension will probably be deferred until next month's meeting.

The MPC's favoured money supply measure – broad money M4 excluding cash holdings of financial intermediaries – is estimated to have risen by a chunky 1.0% in April. Growth has been running at a 7.8% annualised rate so far in 2009, up from just 3.0% during the second half of last year.

QE works by boosting investors' cash holdings, thereby encouraging them to buy private-sector securities. This raises asset prices and makes it easier for companies to float new equity and bond issues. Corporations raised £13.6 billion from sterling capital issues in the three months to April, up from just £3.8 billion in the previous three months.

Stronger monetary growth supports hopes that the economy will stabilise soon. The recent pick-up, however, needs to be sustained to lay the foundations for an economic recovery in late 2009 and 2010.

Most commentators appear to have missed the big story in yesterday's monetary data – the 1.0% rise in the Bank of England's adjusted M4 proxy in April (see previous post). Reports focused instead on the 0.1% monthly contraction in bank lending to households and non-financial corporations. According to the consensus, the lending decline is evidence of a continuing credit crunch and signals further economic weakness.

Three points are worth emphasising. First, empirical analysis shows that money leads the economy whereas credit lags. This is why the US Conference Board includes the real M2 money supply in its index of leading indicators, while real commercial and industrial loans and the ratio of consumer credit to personal disposable income are components of its lagging index.

Secondly, credit trends are nonetheless important to the extent that they influence monetary growth. The MPC, however, has correctly chosen to offset the monetary impact of credit weakness by buying gilts. This policy should and presumably will continue until credit growth revives and resumes its normal role as key driver of monetary expansion.

Thirdly, it is impossible to disentangle supply and demand effects on credit trends. Recent weakness may have been demand-led, reflecting a reduced need for working capital as stocks are run down together with companies taking advantage of more favourable market conditions to float new issues, using the proceeds to repay bank debt.

The adjusted M4 proxy is volatile and it would be unwise to read too much into a single month's increase. The MPC, however, should be reassured by the faster pace of growth so far this year, suggesting that a decision about expanding the QE programme further will be deferred until next month's meeting.

The "best" measure of the UK broad money supply – M4 excluding money holdings of financial intermediaries – grew by 1.0% in April, according to a monthly proxy made available by the Bank of England today. Chain-linking this increase to "official" first-quarter numbers, adjusted M4 is estimated to have risen at a 7.8% annualised rate in the first four months of 2009, up from 3.0% during the second half of 2008. This suggests that QE is working and supports economic recovery hopes.

The 1.0% rise in the adjusted measure in April compares with an increase of just 0.1% in M4 holdings of households and non-financial corporations. The big gap implies that cash balances of financial institutions, excluding intermediaries, rose strongly, probably reflecting the direct and indirect impact of Bank of England asset purchases. Reinvestment of this cash should boost asset prices and money holdings of corporations, as institutions subscribe for new equity and bond issues.

The April broad money rise would have been larger but for a contraction of 0.1% in bank and building society lending to households and non-financial corporations – the first monthly fall since 1993. Lending to households slowed to £2.2 billion, the lowest since August, while corporations repaid £4.7 billion of bank debt, partly out of the proceeds of recent capital issues (sterling issuance totalled £13.7 billion in the three months to April).

Bank of England gilt purchases of £29 billion in April offset £18 billion of DMO (Debt Management Office) issuance, reducing the market-held stock by £11 billion. Sectoral figures show that gilt holdings of overseas and UK non-bank investors fell by £11 billion and £3 billion respectively, while banks and building societies bought £3 billion – see table.

When the Bank buys from a UK non-bank investor, M4 rises as the investor's bank account is credited; there is no such first-round effect with a purchase from a foreign investor, since overseas deposits are excluded from M4. Foreigners, however, appear to have used cash from gilt sales to buy assets from UK institutions and subscribe to new issues, thereby boosting M4 and allowing UK companies to repay bank debt.

Annual growth in adjusted M4 appears to have remained stable at 4.2% in April, since there was an identical 1.0% monthly rise in April 2008. In real terms, i.e. relative to retail prices, the annual rate of change has recovered from a low of -0.7% in September last year to 5.5%. Narrow money trends have also improved, with the annual change in real M1 – currency and sight deposits – up from -5.8% in October to 1.4% in April.