Minutes of the November MPC meeting reveal a 7-2 vote for unchanged rates, in line with our MPC-ometer forecast. A minor surprise was that Gieve joined Blanchflower in seeking a cut, while Bean and Lomax – who opposed the last rise in July – voted for stable rates.

The MPC-ometer forecast for December will be available at the end of next week but I think a 25 b.p. cut is likely. Failure to deliver would sit uneasily with the remarkably dovish November Inflation Report, indicating a 50 b.p. decline is necessary to prevent an inflation undershoot. More straightforwardly, three-month LIBOR has risen by 25 b.p. since the last MPC meeting so an official cut is arguably required just to offset market-led tightening.

The retail run on Northern Rock continued apace in October despite government guarantees on deposits, judging from Building Societies Association savings figures released today. Societies attracted a record £3.0 billion of new receipts, up from £2.8 billion in September and just £770 million in October last year. According to BSA Director-General Adrian Coles, “it seems that the majority of these deposits are funds withdrawn from the Northern Rock bank”.

A conservative guesstimate is that building societies enjoyed additional Rock-related inflows of £2.5-3 billion in September and October combined. With societies accounting for 20% of the retail deposits market, this suggests total withdrawals from the troubled lender of £12.5-15 billion for the two months, equivalent to more than half of its £24.3 billion of retail funding at mid-year.

Money supply figures also released today showed monthly M4 growth of just 0.1%, down from 0.9% in September. Details reveal that the drop reflected a fall in “net sterling lending to non-residents”. This is likely to be related to selling of UK securities by foreigners in the wake of the Northern Rock crisis.

One of my “favourite external links” is to the weekly market comment written by US economist and fund manager John Hussman. Hussman has been downbeat on the US economy for some time but has argued there was insufficient evidence to forecast a recession. He now thinks the balance has tipped, as explained in last week’s comment, titled “Expecting a recession”.

Other forecasters and media pundits have also been piling on the gloom recently. The Economist  this week opined that "recession in America looks increasingly likely".

Hussman's approach is admirably empirical. He describes a “rule of thumb” based on four conditions that have been jointly observed in every US recession. The conditions are:

1. A widening of credit spreads from six months earlier.

2. A flat yield curve, defined as longer-term Treasury yields no more than 2.5% above three-month yields.

3. A fall in the stock market from six months earlier.

4. A purchasing managers’ index for manufacturing of 54 or lower coupled with either non-farm employment growth of less than 1.3% over the prior 12 months or a rise of 0.4 percentage points or more in the unemployment rate from its 12-month low.

Conditions 1, 2 and 4 were met in October and condition 3 is likely to fall into place in November – the S&P 500 has averaged 1478 month-to-date compared with 1511 in May. Hussman therefore now believes a recession is immediately ahead.

The economy was much stronger than the bears forecast in the second and third quarters. I have been expecting a sharp slowdown in growth in the fourth quarter but no recession, at least yet. Should I change my view in light of Hussman’s analysis?

I have to concede that his rule of thumb works well historically. There have been eight US recessions since 1950, according to the National Bureau of Economic Research. Hussman’s indicator gives a signal either before or during all eight. Even more impressively, there are no false signals.

However, it bothers me that the indicator ignores information on the magnitude of the underlying variables. One might reasonably expect the values of the change in credit spreads, yield curve slope, change in stock prices etc. to be relevant to the assessment of the probability of a recession.

To investigate this, I estimated a statistical model for assessing whether the economy is currently in a recession using the values of the Hussman variables. I included current and six-month-ago values to allow for lags in the relationship. The fitted probability estimates of the model are shown in the chart below. Historical performance is similar to the rule of thumb, with all eight recessions since 1950 signalled by the probability rising above 50% and no false signals. However, unlike the simple rule, the model has yet to flash red in the current cycle, with a latest reading of 20%.

I described my own recession probability indicators in an earlier post. The version including credit spreads has been rising recently but has also yet to breach 50% (current reading 45%).

Downside economic risks have clearly increased with further weakness in credit markets and rises in energy costs but I still think a recession can be avoided.

“Other assets” on the Bank of England’s balance sheet rose by £2.0 billion in the week to 14th November following a £500 million gain in the prior week. The cumulative rise since Northern Rock imploded is now £25.3 billion.

Is the Bank providing covert support to banks other than Northern Rock? It is possible but unlikely. In an interview conducted on 1st November Northern Rock chairman Bryan Sanderson stated that the loan was “not quite £20 billion”. This figure compares with estimates from the Bank return of £20.6 billion on 24th October and £22.8 billion on 31st October. Mr. Sanderson may have been referring to the size of the loan a few days earlier, i.e. nearer 24th October than 31st. The discrepancy could also be explained by a rise in other components of the Bank’s “other assets” since it started to lend to Northern Rock. In testimony to the Treasury Committee, Bank of England Governor Mervyn King stated that the Bank was unable to lend covertly to Northern Rock because of the Market Abuses Directive, although this interpretation has been denied by the European Commission. Term interbank rates have been stable in recent weeks and might have been expected to rise if other banks were facing significant funding difficulties.

The November Inflation Report is remarkably dovish and signals the MPC expects to cut Bank rate by 50 b.p. over coming months.

Key points:

1. The two-year-ahead inflation forecast assuming unchanged 5.75% rates is far below target at an estimated 1.75% (both mode and mean). This is the largest negative deviation in the MPC’s history – see chart.

2. The forecast based on market expectations of a 50 b.p. rate cut by the third quarter of next year is exactly on target.

3. The modal GDP forecast based on unchanged rates shows annual growth slowing sharply from 3.3% currently (expected by the Bank to be revised up to 3.5%) to below 2% by the third quarter of 2008.

4. Risks to the forecast are judged to be balanced for inflation and on the downside for growth, versus on the upside and balanced respectively in the August Report.

So why were rates not cut last week? The minutes will reveal more but the MPC probably wanted to set out its revised economic thinking before acting to avoid accusations of bailing out the financial sector. The forecast that inflation will remain slightly above target during 2008 may also have influenced the majority decision to delay.

Time will tell whether recent financial events warrant the MPC’s dramatic forecast revisions; the economy could well prove more resilient than assumed. However, the Committee’s bias is clear and it is reasonable to expect two quarter-point rate cuts by next spring. I will be guided by the MPC-ometer but the first cut could come as early as next month, with a follow-up move possible in February.

The OECD’s composite leading indicator indices are designed to predict industrial activity about six months ahead. They are an important forecasting tool but – like most economic series – are sometimes subject to significant revisions.

The first chart below shows annual growth rates of G7 industrial output and the OECD’s G7 leading index. The latter has recently fallen below zero for the first time since 2005. As mentioned in my last post, I expect G7 industrial growth to fall from its current 2.3% annual rate to 1% or lower by early 2008. Note that the leading index registered similar year-on-year falls in 1995 and 1998 – “soft” landings. Further significant weakness would clearly be concerning, however.

The next chart shows a regional / country breakdown. The G7 index has been depressed by a sharp fall in the Japanese component, in turn partly reflecting a slump in housing starts due to a new stricter procedure for construction approvals. Starts are expected to recover significantly by early 2008 as the new system beds in, reversing some of the decline in the Japanese index and supporting the G7 aggregate.

The chart also shows the US leading index holding up better than those for the Eurozone and UK. This fits with my view that the consensus is too fixated with US economic weakness and is underplaying downside risks in Europe.

The final chart shows that a composite leading index for the “BRICs” (Brazil, Russia, India, China) remains impressively strong despite the G7 slowdown. Continuing robust emerging-world growth is one reason for favouring a “soft” landing scenario for the G7.