Evidence to date suggests that the ECB’s subsidised loans to banks have been much less effective in delivering monetary stimulus than “conventional” QE as practised by the Bank of England.

A positive impact on the supply of money from such policies depends on the banking system increasing lending to, or buying securities from, non-banks (including governments). Banks “finance” a rise in their assets by crediting the deposit accounts of borrowers or sellers of securities with newly-created money*.

The ECB’s lending to banks via its weekly and longer-term refinancing operations rose by €512 billion between the end of November and the end of March. Bank lending to the non-bank private sector, however, fell by €70 billion over the four months, or €32 billion after seasonal adjustment. The decline, admittedly, might have been even larger without the ECB’s additional loans but it is reasonable to conclude that any positive impact was small.

The ECB’s actions have been much more successful in inducing banks to buy government bonds – purchases totalled €127 billion over December-March following sales of €39 billion in the prior four months. Comparing this buying with the €512 billion increase in ECB lending, however, suggests “pass-through” of only 25%.

Contrast this with the Bank of England’s QE2 operation, involving the central bank buying £125 billion of securities directly rather than relying on banks using officially-lent funds to do so. The monetary impact has been slightly reduced by small-scale bank sales of gilts – £15 billion between October, when QE2 started, and March. This still, however, suggests a monetary boost of £110 billion, implying pass-through of 88%.

The ECB, in other words, would have obtained a much bigger “bang for its buck” – three and half times the impact, based on the above figures – by channeling funds directly into government bonds rather than lending to banks. It could, alternatively, have delivered the same amount of stimulus with a much smaller increase in its balance sheet, thereby preserving ammunition likely to be needed in the event of “Grexit”.

April monetary statistics are released next week but the suspicion is that Eurozone money supply trends remain too weak to promote economic recovery, warranting further policy easing. The view here is that this should take the form of country-neutral QE, i.e. bond purchases spread across markets in proportion to GDP. Such an approach would deliver Eurozone-wide stimulus – helpful for “rebalancing” – while limiting risk to the ECB’s balance sheet and avoiding an inappropriate subsidy to peripheral sovereigns (implied by the operation to date of the “securities markets programme”).

*The “banking system” here refers to the central bank plus commercial banks. To the extent that newly-created money is held by overseas residents or governments, it will not show up in published monetary aggregates, which usually cover only domestic private sector holdings. Subsequent transactions, however, may result in the money being transferred to private residents.

Eurosystem gross lending to banks in euros rose by a further €7.1 billion last week to a record €1,339.5 billion, consistent with speculation that institutions in Greece and other peripheral countries are continuing to suffer an outflow of funding, necessitating increased borrowing from the ECB and national central banks.

The gross figure comprises “lending related to monetary policy operations” and “other claims”, under which the Greek and Irish “emergency liquidity assistance” (ELA) operations are recorded. The latter component rose by €4.1 billion last week, probably reflecting additional Greek ELA. This may have been related to last week’s announcement that some Greek banks had been temporarily shifted from regular lending (i.e. “related to monetary policy operations”) to ELA pending recapitalisation.

The switch, however, did not prevent a further €2.9 billion rise in regular loans last week, i.e. any reduction to the affected Greek banks was more than offset by an increase in lending to other institutions.

The suggestion is that that the ECB’s exposure to the periphery is continuing to mount, with a probable parallel rise in Bundesbank exposure to the ECB via TARGET2.

The fall in annual CPI inflation from 3.5% in March to 3.0% in April was slightly smaller than projected here – a 2.9% April print had been expected – and reflects a favourable “base effect” (i.e. an unusually large monthly CPI rise in April 2011 dropping from the 12-month calculation). Motor fuel price relief could maintain the headline rate at 3.0% in May, allowing a welcome suspension of the King / Osborne letter-writing charade. Shorter-term “core” price momentum, however, remains stubbornly strong and inconsistent with a return of inflation to target.

The lower headline annual rate conceals a solid 0.3% monthly rise in the core price measure tracked here – the CPI excluding unprocessed food and energy, adjusted for VAT effects and seasonal factors. The six-month rate of change of this measure (smoothed by taking a three-month moving average) remains near the top of its range in recent years, at 2.9% annualised – see chart.

A partial unwinding of the favourable April base effect in May could be offset by a recent reversal in motor fuel costs that promises to shave 0.2 percentage points from annual CPI inflation – the average price of unleaded has fallen back to about 138 pence per litre from 142.5 pence last month. The outcome may depend on rounding but this could allow the Governor to escape letter-writing duties – triggered by a headline print of 3.1% or higher.

The forecast here remains that CPI inflation will finish 2012 at about 2.75%, based on a small easing of core price momentum and broad stability of commodity prices and the exchange rate. Following the recent upward revision, the Bank’s central projection is similar (the May Inflation Report fan chart numbers will be published tomorrow).

Previous posts have discussed the US recession-warning properties of real narrow money (i.e. currency in circulation plus demand deposits divided by consumer prices). 10 of the 11 post-WW2 downturns identified by the National Bureau of Economic Research (NBER) were preceded by a contraction in real money. The exception was the 1953-54 recession, apparently caused by severe fiscal tightening as defence spending was slashed after the Korean war.

On the basis of this record, posts in 2010 and 2011 expressed scepticism about forecasts at the time – for example by John Hussman* – that the economy was about to enter another recession. Real narrow money grew robustly during 2010-11.

Real money has slowed since late 2011 but was still up by a solid 4.3% (not annualised) in the six months to April – see first chart. Recent posts, therefore, have suggested that US growth will fall back during 2012 while remaining respectable.

Monetary trends, however, bear close scrutiny. Real narrow money was flat between January and April. The latest nominal figure – for 7 May – was 1.8% below the April average, although the weekly series displays considerable volatility.

Also generating some concern here is a recent fall in the Monster index of online job vacancies – the decline in March and April was the largest since the end of the December 2007-June 2009 recession. The index turned down sharply just before the onset of that recession – second chart. (This weakness, however, is at odds with several other labour market leading indicators.)

At the time of writing, the Intrade prediction market was discounting a 16% probability of a recession in 2012, defined as two consecutive negative US GDP quarters between the fourth quarters of 2011 and 2012. The judgement here is that the probability remains well below 50% but is greater than 16%, especially given the risk of spill-over from an escalating Eurozone crisis.

*In his weekly market comment (link to left) of 28 June 2010 Mr Hussman wrote: “Based on evidence that has always and only been observed during or immediately prior to US recessions, the US economy appears headed into a second leg of an unusually challenging downturn.” The comment of 8 August 2011 stated similarly that “the composite of economic and financial evidence we presently observe has always and only been associated with ongoing or immediately impending recessions”. Mr Hussman now expects the NBER to judge that a recession started in May or June 2012, suggesting that one was not “immediately impending” in August 2011.

Previous posts suggested switching from a neutral to defensive stance on equities in response to a fall in a global leading indicator derived from the OECD’s country leading indices. The thinking was that such a decline would confirm the monetary forecast of a slowdown in global growth from the spring, implying increased headwinds for risk assets.

The signal was duly delivered last week – see here – and has been followed by a 4.3% decline in global equities, as measured by the MSCI World index in US dollars. Stocks, however, had already fallen by 6.1% from a 19 March peak, probably reflecting a reescalaton of the Eurozone crisis. Euro woes, in other words, may have advanced and exaggerated the expected risk sell-off.

This, needless to say, complicates investment decision-making. Current equity prices may already discount likely economic weakness – global real money is still expanding, suggesting a slowdown rather than anything worse. A full meltdown of the euro would warrant further falls but the probability of such a scenario is unknowable, depending on the psychology of Spanish and Italian bank depositors as much as, or more than, any decisions by political leaders.

Stocks look short-term oversold based on the put / call ratio and other indicators, while further monetary easing is in train: Chinese repo rates, for example, this week fell to their lowest for a year – see first and second charts. G7 12-month real narrow money growth has yet to cross beneath industrial output expansion, a development that usually precedes major bear phases. There may be a better opportunity to undertake a further defensive shift.

Footnote: An interesting curiosity is that fluctuations in US stocks so far this year resemble those 25 years ago in 1987. A spring sell-off that year bottomed on 21 May and was followed by summer strength before much greater weakness in the autumn – third chart.

The May Inflation Report suggests that more QE is in the offing but the Bank of England is reserving its ammunition until the fall-out from the Eurozone crisis becomes clearer. The Bank, however, continues to deny any responsibility for improving credit conditions, despite believing that credit constraints have contributed to supply-side weakness.

The Report downgraded the Bank’s growth forecast while maintaining a projection of below-target inflation in two years’ time. The mean two-year-ahead inflation expectation based on unchanged policy seems to be 1.8%, the same as in February, based on “eye-balling” the relevant fan chart. This raises the question of why more QE was not announced last week, as suggested by the “MPC-ometer” used here to predict the monthly decision.

One possible explanation is that the Bank felt constrained by another forced upward revision to its shorter-term inflation forecast – the mean projection for the second quarter of 2013, for example, has been raised from 1.65% to an estimated 2.3%. This, however, would be at odds with its usual focus on the two-year horizon, while the Report plays down the significance of the change.

The more likely reason for inaction is that the Bank is waiting for the full horror of the Eurozone crisis to be revealed before calibrating its next programme. Delay, moreover, leaves the door open to co-ordinated action with other central banks, for example in the event of a forced Greek exit from EMU – the Bank may believe this would deliver more “bang for the buck”.