The Fed has hugely increased its lending against lower-quality collateral since the credit crisis broke. It has, however, sterilised the impact of this lending on the volume of cash circulating in the banking system by selling Treasury securities. This was necessary to prevent the fed funds rate from falling beneath its policy target.

The change in the composition of the Fed’s assets has raised concerns about its financial strength. Its non-conventional lending will rise significantly further as a result of the $85 billion credit facility for AIG agreed this week. Sterilising this liquidity injection via further sales of Treasuries would reduce its holdings of such securities to undesirably low levels.

The US authorities therefore yesterday announced a new “supplementary financing programme”, under which the Treasury will sell additional Treasury bills and deposit the proceeds at the Fed. This has the effect of draining liquidity from the market without reducing the Fed’s own holdings of Treasuries further.

Should the Fed follow the example of the Bank of Japan in 2001 and stop sterilising its liquidity injections? The BoJ’s policy of “quantitative easing” flooded the banking system with reserves – see chart – and is argued by some to have been instrumental in Japan’s escape from deflation.

Under current arrangements whereby the Fed does not pay interest on bank reserves, unsterilised liquidity injections would push the Fed funds rate down to zero. The Fed could, however, avoid such an outcome by paying interest on bank balances at close to the fed funds target rate, currently 2%.

The main objection to such a suggestion is that, unlike Japan in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk undermining the dollar and reigniting commodity prices. The surge in the gold price over the last 24 hours is a taster of the possible implications.

Minutes of the September MPC meeting partially vindicate the recent dovish shift in my MPC-ometer. The vote changed from 1-7-1 in August (Besley seeking a 25 bp hike, Blanchflower a 25 bp cut) to 8-1 (Blanchflower voting for a 50 bp cut).

Taking into account the September vote 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.

Exchange rate developments will also be important. MPC members were concerned by the plunge in sterling during August but the effective index is currently 1.5% higher than at the time of the September meeting.

The MPC will wish to avoid the impression of cutting rates to rescue miscreant banks but current financial turmoil clearly has negative implications for credit supply and the wider economy.

Labour market figures also released today showed a shock 32,500 rise in claimant-count unemployment in August, boosting fears that the economy is already in recession. However, my research suggests that job vacancies are a better coincident indicator than unemployment. The 8% drop over the last three months is consistent with stagnant rather than contracting GDP – see chart.

The annual increase in UK consumer prices climbed further to 4.7% in August but retail price inflation slowed from 5.0% to 4.8%. The RPI measure will fall beneath CPI inflation over coming months. The gap between the two may exceed one percentage point by mid 2009 – the largest since 1993.

The chart shows my updated forecasts incorporating the latest numbers. Key assumptions include:

• Unprocessed food price inflation slows gradually from 13% in August to 2.5% by December 2009.
  

• Electricity / gas tariffs rise by a further 10% in September but energy prices are stable thereafter.
  

• “Core” CPI inflation – excluding unprocessed food and energy – slows gradually from recent rates, reflecting economic weakness and a fading impact from sterling’s depreciation.
  

• The housing depreciation component of the RPI, which tracks house prices, falls by 15% by mid 2009, stabilising thereafter. (The CPI excludes housing depreciation.)
  

• Bank rate is cut by half a point to 4.5% by the end of 2008, remaining stable in 2009.
  

On these assumptions, annual CPI inflation returns to the 2% target in September 2009. However, RPI inflation falls below 2% in June next year, reaching 1.1% in September. Of course, further Bank rate cuts during 2009 would imply still-lower RPI numbers.

While lower interest rates 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.

The coming plunge in RPI inflation will lower inflation expectations, subdue wage settlements and boost real income growth. It should also make it easier for the MPC to justify cutting Bank rate while CPI inflation is still above target. I expect the first move to occur as early as next month.

Last week the US authorities rescued Fannie Mae and Freddie Mac, judging them “too big to fail”. This week the authorities have refused to bail out Lehman, on the basis that the firm’s failure is unlikely to trigger a systemic crisis. These judgements are defensible.

The risk of Merrill Lynch being the next domino to fall has been removed by its purchase (at a premium) by Bank of America. With the Fed ready to supply unlimited liquidity against an expanded range of collateral, including equities, fears of financial Armageddon are overdone.

Credit conditions will remain tighter for longer, with negative implications for the economy. However, lower energy prices will provide some offset – global headline inflation is about to fall sharply, boosting real incomes and creating scope for central banks to cut interest rates.

Based on recent crude oil and natural gas prices, the annual change in the energy component of the US consumer price index may fall from +29% in July (August numbers are released tomorrow) to -10% in early 2009 – see chart. Assuming no change in non-energy inflation, this would push headline CPI inflation down from 5.6% in July to about 2% by early next year.

In the UK, CPI inflation is likely to peak at about 4.8% in September before embarking on a steady decline. With wage settlements stable, money growth weakening and the economy stagnant, the MPC should be able to cut interest rates either next month or by November at the latest.

An earlier post argued that UK house prices needed to fall by a further 6% from their July level to bring the rental yield on housing back to its long-term average, assuming stable rents. If the rental yield were to overshoot the average to the same extent that it undershot in 2007, a decline of 21% would be necessary. These could be considered best and worst case scenarios for house prices.

The two scenarios would imply peak-to-trough falls in house prices of 16% and 30% respectively.

Prices dropped by a further 1.8% in August, according to the Halifax index. The required additional declines are therefore now 4% based on the long-term average yield and 19% in the yield overshoot scenario.

The chart below compares the scenarios with the last three house price busts – 1973-77, 1980-82 and 1989-96. The comparison is in real terms – relative to the retail prices index – because general inflation carried a greater burden of valuation adjustment in the prior episodes.

The scenario paths assume that remaining house price adjustment occurs smoothly over two years while the RPI rises by 3% per annum.

In the best case scenario the peak-to-trough decline in real house prices would be much larger than in 1980-82 but less severe than in 1973-77 and 1989-96. The worst case scenario would imply greater damage even than in 1973-77.

Restricted mortgage availability and coming labour market weakness clearly suggest an outcome closer to the worst case. However, prices are now falling faster than at the comparable stage of previous busts. If the decline continues at its recent pace, nominal prices could be nearing a trough by next spring.

An improving trade account has provided major support to the US economy. Net exports contributed 1.7 percentage points to GDP growth of 2.2% in the year to the second quarter.

The consensus is sceptical of a similar positive impact from trade in the UK, despite sterling’s plunge. Independent forecasters expect net exports to contribute 0.3 percentage points to GDP growth in calendar 2008 and 0.4 pp in 2009, according to the Treasury’s monthly survey.

Recent trade figures suggest a larger boost. According to the July release issued this morning, 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. Net trade would then add 0.9 percentage points to calendar 2008 GDP expansion.

The ratio of export to import volumes in July was the highest since 2006 – see chart.