Markets were relieved that banks bid for "only" €132 billion at the ECB's latest three-month refinancing operation today, suggesting that funding pressures are less acute than feared (although that conclusion is provisional pending the results of tomorrow's special six-day operation).

A corollary, however, of the low take-up is that the monetary base (i.e. currency plus banks' current account and deposit facility reserves) is likely to fall significantly when the ECB's €442 billion 12-month facility matures tomorrow. The magnitude of the decline will depend on the six-day operation, among other factors, but could be as much as €250 billion – equivalent to 19% of the monetary base as of the end of last week.

Such a decline would probably put upward pressure on market interest rates – see chart – and would be a further reason for caution about near-term equity market prospects, given the recent strong correlation between the monetary base and stocks in the US discussed in several prior posts.

The Bank of England's favoured broad money measure – M4 excluding deposits held by non-bank financial intermediaries – continued to strengthen in May, arguing against an extension of official gilt-buying. Broad money has surged at a 9.2% annualised rate over the last three months.

Sectoral detail shows that recent growth has been focused on financial institutions – M4 held by households and non-financial corporations rose by 1.5% annualised in the three months to May. Financial money, however, is likely to be transferred to other sectors (e.g. to non-financial firms via purchases of new issues of equities and bonds).

The broad money pick-up is encouraging but narrow money, M1, has recently been a better guide to economic prospects. M1 contracted as the economy entered recession in mid 2008 but recovered strongly in mid 2009, presaging GDP expansion late last year – see first chart. Annual growth has stabilised, consistent with a continuing economic upswing.

The corporate liquidity ratio (i.e. non-financial firms' sterling and foreign currency deposits divided by their bank borrowing) is little changed since March but remains well above its early 2009 low, supporting hopes of a revival in business investment and hiring – second chart.

In terms of the "credit counterparts" arithmetic, the pick-up in the Bank's M4 measure since gilt-buying ended in January mainly reflects a larger offsetting swing in "sterling net non-deposit liabilities". Banks, in other words, had been funding assets through capital issues and longer-term borrowing but have switched to deposit financing more recently.

Reflecting capital flight from the Eurozone, foreign purchases of gilts and Treasury bills were again strong in May at a combined £7.1 billion, though down from £14.9 billion and £18.7 billion respectively in April and March.

Respected fund manager / economist John Hussman argues that the US is entering a "double dip" on the basis of four criteria that, in combination, have identified the last seven recessions (at least). Hussman used the approach in late 2007 to anticipate the 2008-09 contraction.

The criteria are:

1. Wider credit spreads than six months ago.
2. A moderate or flat yield curve, defined as a yield gap of no more than 3.1 percentage points between 10-year Treasury bonds and three-month Treasury bills (currently 2.9).
3. A lower stock market than six months ago, as measured by the S&P 500 index.
4. A manufacturing purchasing managers' index (PMI) at or below 54 coupled with non-farm employment growth of less than an annual 1.3%.

The PMI condition in the fourth criterion has yet to be fulfilled but Hussman argues that this is likely based on recent weakness in the weekly leading index (WLI) compiled by the Economic Cycle Research Institute (ECRI). Indeed, the WLI can be used instead of the PMI and yields nearly identical historical results, with the criterion already met.

Are there any reasons for thinking that "this time could be different"?

One doubt concerns the employment condition in the fourth criterion. In the last seven recessions, the annual growth rate fell beneath 1.3% from above. Employment is currently still lower than a year ago. Is a recovery in growth to above the critical level necessary before a new recession signal can be generated?

In earlier work, moreover, Hussman used a slightly different formulation, with a simpler fourth criterion – a manufacturing PMI of below 50 – and a lower critical value of 2.5 percentage points for the 10-year / three-month Treasury yield gap in the second criterion. Both formulations signalled the recent recession but only the modified version is currently giving a warning. Hussman, presumably, would argue that the new model is superior and provides more of a lead; the old version is likely to follow in due course.

The view here has been that narrow money trends are not yet weak enough to suggest a second recession. The chart shows a US real money measure that has weakened ahead of 10 of the 11 recessions since the second world war, the exception being the 1953-54 downturn, which was triggered by a large fall in government spending following the end of the Korean war. The measure has continued to rise recently, albeit at a slowing pace.

US fiscal policy is scheduled to tighten significantly in 2011 but it is doubtful that the economic impact will be as great as the post-Korean-war cuts – government spending on goods and services fell by a real 6.8% in calendar 1954, cutting 1.64 percentage points directly from GDP.

The UK's inflation performance appears to compare unfavourably with the US – "official" consumer price indices rose by 3.7% and 2.2% respectively in the year to April. The gap, however, largely disappears if US inflation is recalculated using the European Union's "harmonized index of consumer prices" (HICP) methodology. US HICP inflation was an annual 3.5% in April.

The US figure comes from a table of international HICP inflation rates published each month by the US Bureau of Labor Statistics. The UK and US April annual rates of 3.7% and 3.5% compare with 1.5% in the Eurozone and -1.4% in Japan. Similar UK and US inflation experience could reflect identical monetary policy strategies, involving large-scale "quantitative easing" and currency depreciation.

A key difference between the official US consumer price index (CPI) and the HICP is that the latter excludes owner-occupied housing costs, of which the most important component is "owners' equivalent rent" (OER) – a notional payment by homeowners to themselves for accommodation. OER has a 25% weight in the CPI basket and is estimated – based on market rents – to have fallen over the last year, exerting a major drag on official inflation measures.

It is debatable whether OER, involving no cash transaction, should be a component of the CPI basket. An implication of its inclusion is that homeowners' financial position has improved as a result of the recent decline in rents, even though this fall is a lagged consequence of a housing market slump that has slashed the value of their properties – by 32% from peak to trough according to the Case-Shiller house price index.

US "core" inflation (i.e. excluding food and energy) would also be significantly higher using the HICP methodology. A back-of-the-envelope calculation based on the CPI / HICP inflation gap adjusting for the larger weight of OER (32%) in the core basket suggests an April annual rate of about 2% versus an official 0.9%.

The lower official measure, heavily reliant on OER weakness, is helping the Federal Reserve to justify sustaining its super-loose monetary stance and encouraging claims that the US stands on the brink of deflation. The Fed would face a tougher task if required, like the Bank of England, to evaluate inflation performance using the HICP.

The world earnings revisions ratio – the number of analyst upgrades to company earnings forecasts minus downgrades divided by the total number of estimates – turned negative in June for the first time since July last year. The ratio correlates closely with business surveys, suggesting that these will weaken over the summer – see first chart.

It is normal for output momentum to moderate and surveys to soften about a year into an economic recovery as the initial boost from the stocks cycle fades – second chart. The slowdown phase, on average, lasts about six months and is followed by renewed acceleration, although this conceals significant variation.

The emerging slowdown was foreshadowed by weaker real narrow money growth – third chart. Real M1 is still expanding and the rate of increase appears to have stabilised recently, consistent with the view that economic softening represents a "pause to refresh" rather than the start of a "double dip". Further M1 weakness, however, would demand a rethink. 

It would be understandable if some Monetary Policy Committee (MPC) members felt wary about the Osborne-King deal, under which the Chancellor believes he has bought off interest rate rises by acceding to the Governor's demands for accelerated fiscal tightening while transferring supervisory powers to the Bank, including new "macro-prudential" tools to be wielded by a rival Financial Policy Committee. They might, in addition, be uncomfortable with Mr. King's unilateral reinterpretation of the MPC's target as "2% inflation at some point in the future excluding the impact of temporary factors and ignoring any price-level overshoot in the interim".

Such frustrations, perhaps, contributed to external MPC member Andrew Sentance's surprise decision to vote for an immediate quarter-point rate hike this month, despite financial fragility in the Eurozone and the imminent emergency Budget. His view – that accelerating real and nominal growth, persistently high inflation outcomes and doubts about the dampening impact of spare capacity warrant some withdrawal of current exceptional stimulus – is shared, however, by a significant minority of economists, including the four members of the Sunday Times Shadow MPC who also favour immediate tightening (see David Smith's blog for the minutes).

The "MPC-ometer" model – which attempts to forecast the monthly vote based on the latest economic and financial indicators, with indicator weights derived from regression analysis of historical decisions – similarly predicted a three-member minority to hike this month. Yet the minutes suggest little support for Dr. Sentance's argument, with an opposing minority even claiming that downside inflation risks have increased. The Governor, it seems, exerts an iron grip. A decision by the Chancellor to fill the external MPC vacancy with another neo-Keynesian sympathizer will seal the Osborne-King deal and confirm that the inflation-targeting regime has changed.