In forecast presentations late last year I suggested G7 industrial activity was entering a downswing phase. To get an idea of how the slowdown might play out, I examined 10 G7 downswings over the last 40 years, separating them into five “soft” and five “hard” landings – the latter associated with US recessions. I then averaged performance across these two groups to construct “soft” and “hard” landing scenarios for annual G7 industrial output growth in the current cycle.

A key conclusion of the analysis was that “soft” and “hard” landings look similar for the first 12-15 months after a cyclical peak. The averages showed annual output growth slowing steadily to about zero in both cases. It is only after 15-18 months that the two diverge significantly: activity starts to regain momentum in “soft” landings but shifts from stagnation to contraction in “hard” landings / US recessions.

The chart below is an update of one used last year, superimposing the “soft” and “hard” landing scenarios on the current cycle. Annual industrial output growth peaked at 4.5% in September 2006 and fell to 1.7% by June 2007 before recovering to 2.3% in September, the latest reading. The recent minor improvement will be cut short by the “credit crunch” and a renewed decline to 1% or below is likely by early 2008.

As the chart shows, the current downswing is about to reach the critical stage dividing historical “soft” and “hard” landings. Soaring energy costs and escalating credit market losses are clearly unhelpful but I still think the odds favour a "soft" landing like 1995 or 1998 rather than a 2001-style recession.

“Other assets” on the Bank of England’s balance sheet rose by £475 million in the week to yesterday, bringing the cumulative increase since 12th September to £23.3 billion – the best available estimate of the Bank’s loan to Northern Rock.

The weekly rise compares with £2.2 billion last week and is the lowest since Northern Rock imploded. The slowdown is mildly encouraging but the loan is likely to continue to grow near term as wholesale funding matures.

It has been suggested that interest received on the Northern Rock loan will cut the budget deficit by about £2 billion (6.75% on £30 billion over one year). However, such estimates wrongly assume the Bank of England is able to source the funds at zero cost. In fact, the loan has been financed by a cut in the Bank’s repo lending, on which it earns interest, and rises in banks’ reserves at the Bank and other forms of borrowing, on which interest is paid. The budgetary impact will therefore be much smaller – possibly about £300 million (based on a net interest margin of one percentage point on £30 billion for a year).

The “three bears forecast” for the FTSE 100 index worked well in signalling the potential for a strong rally off the August lows. Recent declines have resulted in the index again falling well below the forecast path – see chart. There is no shortage of reasons to worry, from the “credit crunch” to soaring energy costs, but global liquidity remains plentiful, offering significant support for equity prices. Let’s see if this latest buy signal works out.

The impact of the “credit crunch” on the economy remains uncertain but some clues are provided by the Federal Reserve’s October survey of bank lending officers, published yesterday. Key points include:

1. The net percentage of banks tightening mortgage lending standards rose to the highest level since this series started in 1990.

2. The net percentage reporting increased willingness to make consumer installment loans fell below zero for the first time since 2001. Negative readings are unusual outside recessions.

3. The net percentage tightening standards on commercial and industrial loans rose to a four-year high but remains well below levels reached before five of the last six recessions – see chart.

Overall, the survey suggests credit tightening will be a significant drag on fourth-quarter growth but has yet to become severe enough to prompt recession-inducing corporate retrenchment. Surging energy costs are unhelpful but my recession probability model is still indicating a less-than-50% chance of a contraction.

New Star’s MPC-ometer model is forecasting a 7-2 vote for unchanged rates at this week’s meeting (two votes for a 25 b.p. cut). This is the same forecast as last month, when the actual vote turned out to be 8-1, with David Blanchflower the lone dove.

Two key factors have steered the model away from predicting a cut this month. First, GDP was estimated to have grown by a robust 0.8% in the third quarter – the MPC has never eased following a number this strong. Secondly, survey-based measures of consumer and producer inflation expectations remain elevated.

My personal view is that the vote will be closer than the model suggests. The “credit crunch” is difficult to analyse but there is a risk of a large negative impact, justifying giving lower-than-normal weight to recent economic strength. Also, three-month interbank interest rates remain at least 25 b.p. above where they should be at a 5.75% Bank rate, which could argue for an offsetting easing move.

I like to compare the MPC-ometer’s forecasts with the vote of the Sunday Times Shadow MPC. The Shadow MPC was spot on with an 8-1 decision in October and has voted unanimously for unchanged rates this month. Over the last 13 months, the MPC-ometer’s average forecast error has been one vote (0.9 to be precise) versus three votes (2.6) for the Shadow MPC.

Third-quarter figures on bank lending by sector released by the Bank of England today suggest banks provided massive support to off-balance sheet vehicles, hedge funds and other financial intermediaries during the August / September market dislocation. The chart aggregates the flow of new sterling lending to three industries: “other financial intermediaries”, “fund management activities” and “other auxiliary activities”. The third-quarter total of £41 billion is a record and amounts to 19% of the outstanding stock of loans to these industries – equivalent to a 99% annualised growth rate!