Public sector net borrowing totalled £35 billion in 2007/08, equivalent to 2.5% of GDP. The average forecast of economists surveyed by the Treasury is for a rise to £47 billion this year and £50 billion in 2009/10, or about 3 ¼% of GDP in both years. I think the consensus is underestimating the sensitivity of the public finances to the economic cycle. Borrowing could reach about 3 ½% of GDP this year and over 5% in 2009/10, implying nominal figures of £50-55 billion and over £75 billion respectively.

Conceptually, the public sector balance can be split into discretionary and non-discretionary components. The analysis below assumes the government chooses the percentages of GDP accounted for by spending on goods and services and indirect tax revenues. Other elements of the public finances – mainly benefit spending and direct tax receipts – are defined as non-discretionary, i.e. determined by the economic cycle, financial market developments and other factors. (Of course, policy decisions also affect these elements but their impact on year-to-year changes is small relative to cyclical influences.)

The first chart shows annual changes in the non-discretionary public sector balance, defined as above and expressed as a percentage of GDP, together with the fitted values of a model based on current and lagged rates of change of GDP and stock prices. (The labels on the horizontal axis refer to financial years ending in March of the year stated.) Despite its simplicity, the model is able to explain the major swings in the non-discretionary balance over the last 20 years.

Using the model to forecast requires assumptions about GDP and stock prices. GDP is projected to be unchanged between the second quarter of 2008 and the first quarter of 2009 and to grow at an annualised rate of 2% thereafter – close to the current consensus forecast. Similarly, the FT all-share index is assumed to be stable at its current level until the first quarter of next year and then to rise by 10% per annum. Based on these inputs, the model projects a year-over-year deterioration in the non-discretionary balance of 1.1% of GDP in 2008/09 and 1.7% in 2009/10.

The change in the overall public sector balance will also depend on the discretionary component. For simplicity, spending on goods and services and indirect tax revenues are assumed to remain stable as percentages of GDP in 2008/09 and 2009/10. (The former assumption, in particular, may be optimistic given a possible pick-up in public sector wage settlements.)

The second chart shows the overall balance as a percentage of GDP, including the forecasts for 2008/09 and 2009/10. Projected borrowing of 5.3% of GDP in the latter year would be the highest since 1995/96. In a full recession – not the assumption here – borrowing would probably challenge the 7.8% of GDP peak reached in 1994/95.

The measures announced by the US Treasury to support Fannie Mae / Freddie Mac and the US mortgage-backed securities market are comprehensive and should lower the cost and increase the availability of mortgage finance.

Two aspects of the plans are particularly significant. First, Fannie and Freddie will expand their portfolios of retained mortgages and mortgage-backed securities until the end of 2009 before embarking on a controlled reduction. This contrasts with the UK authorities' policy following the rescue of Northern Rock of reducing the bank’s mortgage book by £20 billion a year in 2008 and 2009. As argued previously, this has unnecessarily aggravated mortgage and housing market weakness.

Secondly, the Treasury will buy mortgage-backed securities issued by Fannie and Freddie in the open market, with no predetermined limit on the scale of purchases. Again, there is a contrast with UK policy: the Bank of England's special liquidity scheme allows mortgage-backed debt to be swapped for Treasury bills but has had little positive impact on the prices of such securities because credit risk remains with the banks.

As the chart shows, the woes of Fannie and Freddie have been reflected in a rise in the spread between conventional mortgage rates and interbank swap rates in recent months. A lowering of their funding costs should allow mortgage rates to fall significantly.

A major investment bank believes UK banks will have tapped the Bank of England’s special liquidity scheme to the tune of over £200 billion by the time the drawdown period ends in October. To put this into context, £200 billion is the equivalent of 14% of annual GDP or 6% of banks’ and building societies’ total sterling liabilities.

According to the interim Crosby report on mortgage finance, outstanding UK residential mortgage-backed securities and covered bonds totalled £257 billion at the end of last year. The Financial Times reported in May that banks had created almost £90 billion of additional securities for use under the scheme. So there is sufficient paper available for the £200 billion estimate to be plausible.

However, it is difficult to find corroborating evidence of activity on this scale from Bank of England data on banks’ assets and liabilities. Banks obtaining Treasury bills under the scheme would be expected to use these as collateral for increased repo borrowing. Yet official data show a fall in banks’ repo liabilities of £33 billion between March and July.

It is likely that banks are channelling their SLS activities through off-balance-sheet entities. Such entities were previously used to issue RMBS to the market, with the proceeds routed back to the related bank. They may now be borrowing in the repo market using Treasury bills obtained under the SLS, again on behalf the parent bank. Consistent with this hypothesis, “intermediate other financial companies” increased their deposits with UK banks by an estimated £38 billion in the second quarter. As argued previously, this has resulted in a major upward distortion to M4 money supply growth.

If confirmed, would SLS take-up of £200 billion imply a significant beneficial impact on UK banks? To the extent that the scheme allows banks to avoid a step-up in funding costs when existing wholesale borrowing matures, the effect is to prevent further damage rather than provide a positive benefit. However, it should also have allowed some banks to reduce their average cost of funds.

The scheme is generating significant profits for the authorities. The fee charged on borrowings of Treasury bills is the spread between three-month LIBOR and the three-month general collateral gilt repo rate – currently 70 bp. Assuming an average spread of this level in the first year, and borrowing of £200 billion, the Bank of England would earn £1.4 billion from operating the scheme. This is a multiple of the income the Bank generates annually from its main revenue source, the system of cash ratio deposits, under which banks are required to hold a proportion of their eligible liabilities in a non-interest-bearing deposit at the Bank. SLS profits will presumably be remitted to the Treasury.

Unsurprisingly, my MPC and ECB models signal no change in rates at today’s meetings but both are consistent with an easing bias.

The MPC-ometer suggests either a 5-4 vote for unchanged rates (four votes for a 25 bp cut) or 6-2-1 (two votes for 25 bp, one vote for 50 bp – no prizes). Key contributors to the dovish forecast are the downward revision to second-quarter GDP, a fall in price expectations in the EU consumer survey and lower short-term gilt yields. Partially offsetting these factors are the weak exchange rate and higher share prices.

One caveat: the actual vote has been less dovish than the model’s predictions recently. However, historically it has sometimes been early in picking up shifts in the MPC’s thinking.

For comparison, the Sunday Times Shadow MPC has voted 7-2 for unchanged rates (two votes for a 50 bp cut).

The ECB-ometer, which signalled July’s 25 bp rise, is now suggesting a one-third chance of a cut. Factors contributing to the dovish swing include weak business and consumer surveys, a slight decline in inflation, slowing M3 growth and a fall in short-term bond yields.

With policy tightened only two months ago, officials are understandably reluctant to concede that incoming data now warrant an easing bias. However, there may be some minor changes to the language in today’s policy statement to the effect that either upside inflation risks have diminished slightly or – more likely – downside growth risks have increased.

The first revision to second-quarter GDP, published on Friday 22 August, downgraded growth from the first quarter from 0.2% to zero. According to press reports, this was the weakest performance since the second quarter of 1992 – the tail-end of the last recession.

Such statements are wrong because they compare the first revision to the latest quarter with final GDP estimates for prior quarters. In fact, there were three quarters after 1992 for which the first revision indicated no growth in GDP – the first quarter of 1999, the fourth quarter of 2001 and the first quarter of 2002. The latest data shows GDP increases of 0.4%, 0.4% and 0.5% respectively for the three quarters. Clearly, there is a significant chance that the current second-quarter number will be revised higher.

The OECD yesterday published forecasts showing GDP declining at annualised rates of 0.3% and 0.4% in the third and fourth quarters, satisfying one definition of a recession. However, the OECD quotes a standard error of 1.2% around its projections, implying the forecast declines are not statistically significant. Moreover, according to a footnote, the UK model has been revised to include residential property prices, which are thought to be important currently, but the change causes a deterioration in historical tracking performance. In other words, the OECD has intervened judgementally in the statistical forecasting process in a way likely to have resulted in more negative projections.

The OECD’s forecasts are hardly authoritative. Back in March, the organisation projected no change in US GDP in the second quarter. The latest estimate shows growth of 3.3% annualised.

The modest improvement in services sector activity reported in today’s purchasing managers’ survey for August is a welcome antidote to current excessive economic gloom. As suggested in a previous post, business and consumer surveys earlier in the summer were artificially depressed by the temporary surge in oil prices. Taking into account manufacturing and construction results released earlier in the week, the PMI surveys are consistent with a stagnant rather than contracting economy.

In an article discussing economic prospects and policy options, former MPC member Charles Goodhart has argued that the Debt Management Office should reduce gilt issuance in favour of increased sales of short-term Treasury bills. This is an excellent idea: it would help to arrest the recent worrying slump in broad money supply growth and is a more appropriate response to current conditions than a cut in official rates.

A government running a budget deficit injects money into the economy. If the deficit is financed by selling gilts to the non-bank private sector, the cash injection is reversed, leaving the money supply unchanged. However, sales of Treasury bills are less likely to have this sterilising effect, because they are bought mainly by banks rather than non-banks. So the combination of the budget deficit with Treasury bill financing boosts the money supply.

Annual growth in adjusted broad money M4 – excluding deposits of intermediate “other financial companies” – fell from 13.6% to 6.5% between June 2007 and June 2008. In the second quarter alone adjusted M4 rose by only 3% annualised. I think M4 growth of 6-8% per annum is consistent with achievement of the inflation target over the medium term. A lower rate of expansion would risk unnecessary economic weakness and an inflation undershoot.

Goodhart’s proposal offers a way of boosting monetary growth without cutting official interest rates – risky against a backdrop of high inflation expectations, sterling depreciation and fiscal deterioration. Suppose the DMO switched half of the financing of a £50 billion annual budget deficit from gilt sales to the non-bank private sector to Treasury bill sales to banks. Ceteris paribus, this would boost annual broad money growth by 1.4 percentage points.

As discussed previously, the authorities could also support monetary expansion and the housing market by slowing down the rate of contraction of Northern Rock’s balance sheet.

The Goodhart suggestion is the mirror-image of proposals made in 2006/2007 for the DMO to curb then-rampant monetary expansion by “overfunding” the budget deficit through additional gilt issuance. This would have helped to limit credit and housing market excesses.

The Treasury and Bank of England ignored such proposals at the time. As Goodhart notes, his latest policy suggestion would require more gumption on the part of the authorities than has been shown to date.