Detailed monetary statistics for August released by the Bank of England yesterday suggest a further deterioration in near-term economic prospects. In particular:

• M4 excluding money holdings of financial corporations rose by 5.4% in the year to August, the lowest annual growth rate since 2000 and barely higher than retail price inflation of 4.8%. The increase in the three months to August was just 3.3% annualised.
  

• Narrow money M1, comprising currency holdings and sight deposits, was 0.6% lower in August than a year before, the first annual decline since 1969.
  

• M4 held by private non-financial corporations (PNFCs) fell for the fifth month out of the last six and is now down 2.8% from a year ago. With bank lending to PNFCs continuing to rise, the corporate liquidity ratio – money holdings divided by borrowing – reached its lowest level since 1991.
  

• Public sector deposits with UK banks rose by £18 billion in August, offsetting a £16 billion decline in interbank deposits. There may be an innocent explanation but this suggests covert official support for one or more struggling banks.
  

M4, M1 and the corporate liquidity ratio are inputs to my recession probability model, designed to estimate the chances of an annual decline in GDP three quarters ahead. Also taking into account recent upward pressure on unsecured interbank interest rates and credit spreads, the model now suggests a 55% chance of an annual fall in GDP by the second quarter of 2009 – see first chart.

While above 50%, the probability estimate is still significantly lower than the 80% plus levels reached before the last three recessions. The model projects an annual GDP decline of 0.2% in the second quarter of next year, implying a stagnant or mildly contracting economy rather than a full-scale downturn – see second chart.

According to the model, the outlook is less negative than before prior recessions because of a smaller rise in interest rates and the large fall in the effective exchange rate over the last year, which will support net exports. The latter effect is already evident: trade contributed 0.5 percentage points to GDP growth between the fourth and second quarters.

Incidentally, revised GDP figures released today support my view that the economy had not entered a recession before recent financial eruptions. Excluding volatile oil and gas production, output edged 0.05% higher in the second quarter. Available evidence suggests activity remained broadly flat in July and August.

Federal Reserve Bank credit – the Fed’s aggregate lending to the banking system – rose by an unprecedented $219 billion, or 22%, in the week to last Wednesday. This reflected increases in currency swaps with other central banks, lending to banks to finance purchases of asset-backed commercial paper, primary dealer and other broker-dealer credit and the AIG loan.

The annual growth rate of Fed credit is now 32%, exceeding the levels reached at end-1999, when the Y2K computer scare led to a precautionary dash for cash, and after the 911 terrorist attacks, which temporarily disrupted the payments system – see first chart.

A key issue is whether the Fed will fully sterilise the impact of its increased lending on the monetary base (i.e. currency in circulation and bank reserves held with the Fed) – failure to do so would amount to “printing money”. As the chart shows, monetary base growth also rose sharply last week but this may reflect the technical difficulty of sterilising such a large injection immediately.

The short-term rise in bank reserves has pushed the actual level of the Fed funds rate well below the 2% target – see second chart. This amounts to an effective easing of policy, albeit possibly temporary.

While the jury is out, I doubt the Fed is yet ready to embark on an explicit policy of expanding the monetary base. Unlike Japan before its adoption of “quantitative easing” in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk a collapse in the dollar and a sharp rise in Treasury yields, exacerbating current financial difficulties.

Unsecured interbank lending rates have shot up in the wake of the multiple financial shocks of the last fortnight.

In the US, banks can partially offset the impact of rising unsecured rates on their average cost of funds by increasing their borrowing from the Fed’s discount window (or "primary credit facility"). Cash is available for up to 90 days at an interest rate of 2.25% (a 25bp premium to the Fed funds target rate) versus today’s three-month dollar LIBOR fixing of 3.77%. While borrowing is secured, collateral rules are loose, with mortgages, corporate securities and asset-backed commercial paper eligible.

UK banks are at a disadvantage to their US counterparts because there is no equivalent Bank of England credit line. The Bank’s version of the discount window is its “standing lending facility”, which offers overnight funds at 1% above Bank rate against only the highest-quality collateral. The facility has remained unused throughout all of the last year’s financial calamities. The Bank has promised reform of its money market operating arrangements but it is unclear how the SLF will change.

The Bank’s alternative to the Fed’s generous discount window is the special liquidity scheme, under which banks can swap lower-quality collateral for newly-minted Treasury bills. These bills can then be used to obtain cheaper secured funds in the gilt repo market. However, banks must pay the Bank a fee equivalent to the spread between three-month LIBOR and the three-month gilt repo rate. The SLS improves liquidity but banks still end up paying LIBOR to raise funds. By contrast, the Fed’s lending both boosts liquidity and reduces average funding costs.

The Fed effectively creates money at the 2% Fed funds rate and lends it out via the discount window at 2.25%, earning a 25bp margin. The Bank of England is raking in much larger profits from the SLS, with the spread between three-month LIBOR and the three-month gilt repo rate ranging from 50bp to the current extreme 150bp since the scheme’s inception. Assuming average usage of £200 billion in the first year at a spread of 75bp, the Bank will earn £1.5 billion or £4 million a day.

The Bank argues that the current fee structure is necessary to avoid subsidising banks. However, this assumes LIBOR is a valid price determined in functioning markets by rational agents – clearly not the case at present.

Any bank using the SLS to obtain collateral and raise funds this week will lock in current high LIBOR borrowing costs for three months. Only those in severe difficulty are likely to accept such terms. By design, the scheme becomes more expensive precisely when banks need it most.

Two modest changes to address these deficiencies would be: 1) base the fee on the average LIBOR / gilt repo rate spread over the following three months rather than its starting level; and 2) set a maximum of 75bp (there is already a floor of 20bp).

Such modifications would probably have little impact on LIBOR itself but would partially relieve upward pressure on banks’ funding costs and, by extension, household and corporate borrowing rates.

Does the economy face a temporary period of stagnation or mild contraction to be followed by a recovery from the first half of 2009, or a full-scale recession of the sort experienced in the mid 1970s, early 1980s and early 1990s, involving a fall of several percentage points in GDP over a period of at least a year?. These notes have argued in favour of the former scenario for three main reasons: the interest-servicing burden on households has increased less sharply than before prior recessions; monetary growth has weakened to a lesser extent, at least to date; and the large fall in the sterling exchange rate over the past year should offer external support to UK activity.

Recent extraordinary financial events have clearly increased the risk of a full recession. In particular, financial turmoil may cause consumers and businesses to postpone spending decisions, possibly initiating a self-feeding economic downturn. However, the judgement here is that the less malign scenario remains the more likely, albeit involving a bumpier ride than previously envisaged. As explained further below, not all recent developments have been discouraging. The latest trade figures support optimism that net exports will cushion domestic demand weakness. Annual retail price inflation should fall precipitously over the next 12 months, providing a welcome boost to spending power. Meanwhile, financial events have created scope for the MPC to cut official rates earlier and by more than was previously likely without damaging its inflation-fighting credibility.

An improving trade account has provided major support to the US economy, with net exports contributing 1.7 percentage points to GDP growth of 2.2% in the year to the second quarter. The consensus has been sceptical of a comparable trade boost to UK activity, despite sterling’s plunge and the much higher shares of exports and imports in GDP. Independent forecasters expect net exports to contribute 0.4pp to GDP growth in calendar 2008 and 0.6pp in 2009, according to the Treasury’s monthly survey. Recent figures suggest a larger boost. Export volumes of goods excluding oil and erratic items were 3.6% above their 2007 average in June / July versus a rise of just 0.2% in imports. Suppose total real exports and imports, including services, grow at these rates for the year as a whole – plausible given that the full benefit of sterling depreciation has yet to be felt. Net trade would then add 0.9pp to calendar 2008 GDP expansion.

While the credit crisis is more often blamed, a squeeze on real income and money supply growth caused by this year’s surge in inflation has also contributed significantly to current economic weakness. The potential benefit from a likely reversal of this spike should therefore not be underestimated. The chart shows forecasts for annual CPI and RPI inflation through to the end of 2009 based on the following assumptions: 1) unprocessed food price inflation slows gradually from 13% in August to 2.5% by December 2009; 2) electricity / gas tariffs rise by a further 10% in September but energy prices are stable thereafter; 3) “core” CPI inflation – excluding unprocessed food and energy – slows gradually from recent rates, reflecting economic weakness and a fading impact from sterling’s decline; 4) the housing depreciation component of the RPI, which tracks house prices, falls by 15% by mid 2009, stabilising thereafter; and 5) Bank rate is cut by half a point to 4.5% by the end of 2008 (see below), remaining stable in 2009. On these assumptions, annual CPI inflation returns to the 2% target in September 2009 while RPI inflation falls below 2% in June next year, reaching 1.1% in September. Of course, further official rate cuts during 2009 would imply still-lower RPI numbers. While interest rate reductions contribute, falling house prices are the key reason for the forecast RPI / CPI divergence. The housing depreciation component carries a 5.5% weight in the RPI so the assumed 15% annual decline in mid 2009 subtracts 0.8 percentage points from the annual RPI increase.

Minutes of the September MPC meeting partially vindicate the recent dovish shift in the MPC-ometer model described in previous monthly notes. The vote changed from 1-7-1 in August (Besley seeking a 25bp hike, Blanchflower a 25bp cut) to 8-1 (Blanchflower voting for a 50bp cut). Taking into account the September outcome and available data on the other inputs, the model suggests a knife-edge October decision. Further weakness in consumer and business surveys released in late September and early October – plausible in light of recent financial events – would tip the balance in favour of a cut. Market developments will also be important. MPC members were concerned by the plunge in sterling during August but the effective index is currently 3% higher than at the time of the September meeting. Meanwhile, recent rises in unsecured interbank lending rates, unless rapidly reversed, threaten renewed upward pressure on household and corporate borrowing costs. As conventionally used, the MPC-ometer attempts to answer the question of whether a change in Bank rate is warranted by incoming economic and financial data. If the target is changed from Bank rate to three-month LIBOR, currently 6.1%, the model suggests a near-certain 25bp October cut and a further 50bp reduction by year-end, based on plausible assumptions about the inputs. Against these arguments, the MPC may feel itself constrained by a further rise in annual CPI inflation in September, possibly to 5% or above, as well as rapidly deteriorating fiscal prospects, which could undermine confidence in the wider macroeconomic policy framework. However, the disinflationary shock implied by recent financial events should allow the Committee to play down the former, while fiscal profligacy may affect the extent of the peak-to-trough decline in rates rather than the timing of the first cut.

Some commentators have suggested the Paulson / Bernanke financial rescue plan represents a “monetisation” of illiquid mortgage-backed securities, implying longer-term inflationary consequences. On current information, such concerns appear unwarranted.

“Monetisation” would involve one or both of the following:

• An increase in the monetary base, i.e. currency in circulation and banks’ reserves held at the Fed.

• An increase in the broad money supply, i.e. cash, deposits and other liquid assets held by the non-bank private sector.

The Fed has hugely expanded its lending to the banking system against lower-quality collateral over the last 12 months but has sterilised the impact on the monetary base by selling Treasury securities. There is no current reason to think this approach will change. The further measures announced in recent days – including the loan to AIG, a new facility allowing banks to borrow to buy asset-backed commercial paper and planned Fed purchases of agency securities – will be financed mainly by the Treasury issuing additional bills and depositing the proceeds with the Fed, implying no impact on bank reserves.

Under current arrangements whereby the Fed does not pay interest on bank reserves, failure to sterilise the impact of its lending on the monetary base would push the effective fed funds rate down to zero. To keep the rate near the policy target of 2% while expanding the monetary base, the Fed would have to start paying interest on reserves at close to this level. There has yet to be any discussion of this possibility.

With respect to the broad money supply, the key point is that the Paulson / Bernanke plan involves the government buying suspect assets from banks rather than non-banks so there is no direct impact on the money holdings of the latter. If the scheme is financed by selling additional Treasury bills to banks, the net effect will be to increase the proportion of high-quality liquid securities on their balance sheets while leaving total assets unchanged. To the extent that funds are raised by selling additional Treasury securities to the non-bank private sector, there will actually be a negative first-round impact on the broad money supply and aggregate bank assets.

Of course, a successful scheme resulting in a normalisation of money and credit markets would increase banks’ willingness to lend, implying an indirect boost to monetary expansion.

Should the US authorities consider measures to boost broad money growth as part of their efforts to restore financial stability and stave off economic weakness? My favoured broad liquidity measure – M2 plus institutional money funds, commercial bank large time deposits and commercial paper outstanding – is still rising at a 9% annual rate, suggesting concern over monetary deficiency is premature. However, the shorter-term trend is weaker and bears close monitoring – see chart.

The Resolution Trust Corporation (RTC) was set up in 1989 to manage and dispose of the assets of failed savings and loan (thrift) institutions. According to a General Accounting Office report, the RTC closed 747 institutions with $402 billion in book value of assets. By the time it was wound up in December 1995, the RTC’s remaining assets were down to $8 billion and it had incurred estimated direct losses of $88 billion.

The Treasury, Federal Reserve and Congressional leaders are reportedly discussing plans to create an RTC-type body to purchase so-called failed assets from US financial institutions. Such an approach has been endorsed by a former Fed chairman, a former Treasury secretary and a former US comptroller of the currency. The original RTC, however, assumed assets only after savings institutions had failed and been placed into conservatorship (the current status of Fannie Mae and Freddie Mac) or receivership. By contrast, the latest proposal is designed to prevent further financial failures.

The original RTC bailed out the depositors of failing institutions but not equity-holders or junior creditors. Market participants are betting that the new scheme will be different, contributing – together with the ban on new short sales – to today’s surge in financial shares. The benefit to equity-owners, however, will depend on the price at which any new RTC-type body purchases toxic assets. Who will establish the “correct” level, and how? Too high a price will enflame criticisms of a bail-out and bolster calls for tighter regulation. Too low a price risks leaving banks with insufficient capital to weather future financial storms.