Monday’s Pre-Budget Report will be accompanied by a revision to the Debt Management Office’s financing plans for 2008-09. The DMO could support broad money growth by cutting planned gilt issuance and boosting sales of Treasury bills. Unfortunately, there is little sign such action is being contemplated.

When the authorities fund a budget deficit by selling gilts to the non-bank private sector, there is no net impact on the money supply – the injection of funds due to the deficit is offset by a transfer of cash out of bank deposits to pay for the new gilts.

Treasury bills are more likely to be bought by banks than non-banks. When banks provide funding there is no transfer of cash out of deposits held by non-banks so the injection due to the deficit is reflected in an increase in the money supply.

Under current plans the DMO will sell £116 billion of debt in 2008-09, comprising £110 billion of gilts and £6 billion of Treasury bills. Gilt sales have totalled £74 billion in the year to date, implying a further £36 billion by the end of March. The £116 billion full-year target is likely to be raised next week, reflecting a higher official forecast for public net borrowing. Suppose funding of £50 billion will be required over the remainder of 2008-09. If the DMO were to raise this amount by selling Treasury bills to banks rather than gilts to non-banks, broad money – measured by adjusted M4 (i.e. excluding deposits of financial intermediaries) – would expand by about 3%.

Annual growth in adjusted M4 was just 3.7% in September, according to the Bank of England (see chart 1.3 on p.11 of the November Inflation Report). On reasonable assumptions, a rate of increase of 6-8% per annum is compatible with achievement of the inflation target over the medium term. Replacing gilt issuance with Treasury bill sales over the remainder of 2008-09 would offset the impact of credit weakness on monetary growth, reducing the risk of a future inflation shortfall.

Economic models are prone to break down under extreme conditions. My MPC-ometer did not forecast the 150 bp Bank rate cut in November but it did indicate a larger reduction, of 75-100 bp, than expected by most economists - see here.

The December forecast will depend importantly on consumer and business survey results released around the end of the month. However, based on current information, the model suggests a cut of no more than 50 bp. A significant minority of economists expects a larger move, according to a Reuters poll conducted last week.

One property of the model is that the data hurdle for policy easing becomes higher as the absolute level of rates falls. Other factors holding it back from predicting a larger move are the recent further slump in the exchange rate and the MPC’s tendency to concentrate action in Inflation Report months.

Minutes of the November meeting released today indicate the MPC believes a further cut of more than 50 bp is warranted by the Inflation Report projections. However, these projections are subject to revision to take account of the fall in sterling (currently 6% below the level assumed in the Report) and fiscal loosening to be announced in the Pre-Budget Report. In addition, some MPC members argued that staggering a further reduction could help to support confidence as the economy weakens.

G7 three-month LIBOR – a weighted average of individual currency rates – has fully reversed its September / October spike and is now below levels prevailing before Lehman failed. 10-year interbank rates are also at a new low – see chart.

Less encouragingly, the fall in LIBOR has been entirely due to actual and expected cuts in official rates, reflected in a large decline in overnight indexed swap (OIS) rates. LIBOR / OIS spreads remain significantly higher than in early September.

The lower absolute level of rates will support the economy, partly by boosting the disposable income of borrowers whose loans are tied to LIBOR or policy rates. However, banks’ continuing difficulties in raising wholesale funds, reflected in high LIBOR / OIS spreads, will constrain the supply of new credit.

As argued previously, policy-makers need to shift emphasis from official rate cuts to direct measures to boost money and credit, such as underfunding budget deficits, buying private sector assets and guaranteeing lending to firms and households.

Incentivising Northern Rock managers to run down its mortgage book at maximum speed never made sense in a wider financial and economic context – as argued here.

According to the Sunday Times, the government is now seeking Brussels clearance to delay further repayment of the Treasury loan, implying Rock will offer more attractive refinancing terms to its borrowers in order to keep their business. The new approach would presumably extend to the Bradford and Bingley mortgage book.

The article also suggests that the final Crosby report next week will propose a government guarantee scheme for mortgage-backed securities. This could further loosen mortgage supply – but only if the fees are set at a significantly lower level than for the existing credit guarantee scheme.

Let’s see if these reports are confirmed.

Banks need to boost their profitability in order to generate additional capital to support higher lending. Yet a measure of the gap between their average lending and deposit rates is close to its lowest level for at least 10 years.

Recent government-sponsored capital injections were calibrated to provide banks with a buffer against coming loan losses rather than support an expansion of lending. With market capital available, if at all, only on penal terms, banks are reliant on retained earnings to build the additional cushion necessary to support lending growth.

Net interest income is the largest element of banks’ earnings. The chart below shows estimates of average interest rates on banks’ and building societies’ sterling lending to the private sector and their M4 deposit liabilities. The estimates are derived from Bank of England data on effective interest rates on different types of loan and the composition of balance sheets.

The gap between the average lending and deposit rates – the net interest margin – recently reached its lowest level in the history of the data since 1999.

This may understate current pressure on banks’ profitability for three reasons. First, a compression of the margin from 2003 was offset by rapid balance sheet expansion, which is now ending.

Secondly, sterling lending exceeds M4 deposits by £476 billion, with the resulting “funding gap” bridged mainly by wholesale market borrowing. The cost of such borrowing has risen significantly since the credit crisis erupted.

Thirdly, fee income has fallen in reflection of weakness in financial markets.

Cuts in Bank rate may not boost the net interest margin much, if at all. Suppose the average loan rate is linked to Bank rate while the deposit rate varies with interbank rates – this is a simplifying assumption but may contain an element of truth, given government pressure to “pass on” Bank rate cuts and competition for savings. Bank rate cuts that were not fully reflected in interbank rates would then reduce the margin.

The three-month overnight indexed swap (OIS) rate – which measures market expectations of Bank rate – is currently 280 bp below its average in September (the last date in the chart), while three-month LIBOR is only 170 bp lower (based on yesterday’s fixing). Actual and prospective cuts in Bank rate have therefore yet to be fully reflected in interbank rates.

The government is further contributing to earnings woes via the charges levied for its various support measures. The fees on the special liquidity and credit guarantee schemes are significantly higher than for their US equivalents, as is the coupon on government-purchased preference shares. Banks are also partially liable for the cost of recent payouts to depositors under the Financial Services Compensation Scheme.

The November Inflation Report published today is very dovish and will boost expectations of a fall in Bank rate to below 2% by early 2009. In his press conference comments, Mr. King also appeared to welcome substantial fiscal loosening while playing down concerns about the plunge in the exchange rate. However, the commitment to maximum policy stimulus sits oddly with the Report’s forecast of a relatively shallow and short recession. Markets may begin to worry about a loss of financial discipline.

Key points:

• The mean CPI inflation forecast in two years’ time based on an unchanged 3% Bank rate is just 0.9%, by far the largest deviation from target in the MPC’s history – see chart. This compares with an above-target forecast of 2.2% in August.

• The associated fan chart implies a 20% plus chance of CPI inflation being below zero in two years’ time.

• While it is difficult to infer precise figures from the chart, the growth forecast based on unchanged rates is consistent with GDP declining by about 0.5% per quarter between Q4 2008 and Q2 2009, stabilising in Q3 and then recovering by 0.5% per quarter over the following year. This would imply a peak-to-trough decline in GDP of about 2%, with annual average changes of -1.3% in 2009 and +1.7% in 2010.

• As discussed in a previous note, an average path derived from the last three recessions would entail a peak-to-trough fall in GDP of 2.3% with a recovery delayed until Q2 2010. This path would imply an annual fall of 1.7% in 2009 with growth of just 0.4% in 2010.

• Mr. King also stated that an updated growth projection would be less gloomy because of prospective fiscal loosening and recent sterling weakness.

• The large and sustained inflation undershoot is questionable against the background of a moderate recession and a substantial fall in the exchange rate. Either the MPC’s GDP forecasts are insufficiently downbeat or inflation is likely to revive sooner than the Report projects.