“Other assets” on the Bank of England’s balance sheet rose by £2.0 billion in the week to 14th November following a £500 million gain in the prior week. The cumulative rise since Northern Rock imploded is now £25.3 billion.

Is the Bank providing covert support to banks other than Northern Rock? It is possible but unlikely. In an interview conducted on 1st November Northern Rock chairman Bryan Sanderson stated that the loan was “not quite £20 billion”. This figure compares with estimates from the Bank return of £20.6 billion on 24th October and £22.8 billion on 31st October. Mr. Sanderson may have been referring to the size of the loan a few days earlier, i.e. nearer 24th October than 31st. The discrepancy could also be explained by a rise in other components of the Bank’s “other assets” since it started to lend to Northern Rock. In testimony to the Treasury Committee, Bank of England Governor Mervyn King stated that the Bank was unable to lend covertly to Northern Rock because of the Market Abuses Directive, although this interpretation has been denied by the European Commission. Term interbank rates have been stable in recent weeks and might have been expected to rise if other banks were facing significant funding difficulties.

The November Inflation Report is remarkably dovish and signals the MPC expects to cut Bank rate by 50 b.p. over coming months.

Key points:

1. The two-year-ahead inflation forecast assuming unchanged 5.75% rates is far below target at an estimated 1.75% (both mode and mean). This is the largest negative deviation in the MPC’s history – see chart.

2. The forecast based on market expectations of a 50 b.p. rate cut by the third quarter of next year is exactly on target.

3. The modal GDP forecast based on unchanged rates shows annual growth slowing sharply from 3.3% currently (expected by the Bank to be revised up to 3.5%) to below 2% by the third quarter of 2008.

4. Risks to the forecast are judged to be balanced for inflation and on the downside for growth, versus on the upside and balanced respectively in the August Report.

So why were rates not cut last week? The minutes will reveal more but the MPC probably wanted to set out its revised economic thinking before acting to avoid accusations of bailing out the financial sector. The forecast that inflation will remain slightly above target during 2008 may also have influenced the majority decision to delay.

Time will tell whether recent financial events warrant the MPC’s dramatic forecast revisions; the economy could well prove more resilient than assumed. However, the Committee’s bias is clear and it is reasonable to expect two quarter-point rate cuts by next spring. I will be guided by the MPC-ometer but the first cut could come as early as next month, with a follow-up move possible in February.

The OECD’s composite leading indicator indices are designed to predict industrial activity about six months ahead. They are an important forecasting tool but – like most economic series – are sometimes subject to significant revisions.

The first chart below shows annual growth rates of G7 industrial output and the OECD’s G7 leading index. The latter has recently fallen below zero for the first time since 2005. As mentioned in my last post, I expect G7 industrial growth to fall from its current 2.3% annual rate to 1% or lower by early 2008. Note that the leading index registered similar year-on-year falls in 1995 and 1998 – “soft” landings. Further significant weakness would clearly be concerning, however.

The next chart shows a regional / country breakdown. The G7 index has been depressed by a sharp fall in the Japanese component, in turn partly reflecting a slump in housing starts due to a new stricter procedure for construction approvals. Starts are expected to recover significantly by early 2008 as the new system beds in, reversing some of the decline in the Japanese index and supporting the G7 aggregate.

The chart also shows the US leading index holding up better than those for the Eurozone and UK. This fits with my view that the consensus is too fixated with US economic weakness and is underplaying downside risks in Europe.

The final chart shows that a composite leading index for the “BRICs” (Brazil, Russia, India, China) remains impressively strong despite the G7 slowdown. Continuing robust emerging-world growth is one reason for favouring a “soft” landing scenario for the G7.

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.