There is a scare story doing the rounds about US banks “running out of cash at the Fed”. This is based on the Fed’s H.3 statistical release, showing that “non-borrowed reserves of depository institutions” (second column of table) turned negative in the latest fortnight.

The story revolves around a misunderstanding. The Fed supplies cash reserves to the banking system either via sale-and-repurchase agreements (repos) or lending from the discount window or more recently under the Term Auction Facility. Only repo-sourced reserves are classified as “non-borrowed”.

Banks have recently taken advantage of the TAF to source their needed reserves so repos have fallen, pushing non-borrowed reserves into negative territory. However, total reserves have remained stable (first column) and above the level dictated by reserve requirements (third column). There is no aggregate shortage of cash at the Fed. Banks have chosen to use the TAF because they can obtain longer-term funds against a wide range of collateral.

If there were any shortage of cash the fed funds rate would be trading above the Fed’s 3.0% target. It has been below the target on average so far this week.

Fear levels are about as high as they get when such stories are taken seriously.

Today’s decisions by the MPC and ECB were refreshingly boring.

The MPC cut Bank Rate by 25 bp and issued a balanced policy statement referring again to the opposing risks posed by slowing growth and elevated inflation expectations. Unlike the ECB, the MPC does not use these statements to signal its intentions, which will be communicated in next week’s Inflation Report.

The ECB statement retained references to upside inflation risks and a need to “monitor very closely” all developments but indicated heightened uncertainty and greater concern about the outlook for economic activity. The changes were marginal but consistent with the view that events are playing out similarly to early 2001, in which case rates are likely to be cut some time in the second quarter – see last post.

I have updated the ECB-ometer forecast for tomorrow’s meeting, last discussed here. Despite elevated inflation indicators, weakness in yesterday’s services PMI and last week’s consumer survey have contributed to a fall in the “average interest rate recommendation” from -2 bp to -6 bp. While insufficient to generate a forecast of a rate cut (recommendation of below -12.5 bp required), this suggests the ECB should now have an easing bias.

The ECB’s behaviour in 2001 may provide guidance on how the central bank will manage a shift from its current hawkish stance to an eventual rate cut. In January 2001 the policy statement in the ECB’s Monthly Bulletin talked of “upside risks to price stability which warrant close monitoring” – a similar formulation to that used in recent press conferences. The February Bulletin retained a reference to “close monitoring” and upside dangers but stated that “risks to price stability … appear more balanced”. In March “close monitoring” was replaced by an assurance that the Governing Council was “firmly committed to price stability”. This in turn was softened to “will continue to focus on maintaining price stability” in April, after which the repo rate was finally cut by 25 bp in May.

As now, inflation was a constraint on early action in 2001, with the annual increase in consumer prices hitting a high of 3.1% in May, the month of the first cut. The ECB-ometer’s forecasts also looked similar in early 2001 – see chart. One key difference was the euro, which had fallen significantly against other major currencies in 1999 and 2000.

If 2001 is a guide, the ECB may begin the shift towards easing by modifying tomorrow’s statement to indicate that risks to price stability remain on the upside but are diminishing because of slowing growth. This would be consistent with an eventual cut some time in the second quarter. A more dramatic shift in language is probably needed to signal the possibility of earlier action.

Two important pieces of US economic news have been released over the last 24 hours.

The first was the Fed’s quarterly survey of senior loan officers, conducted during the first half of January. As expected, this reported a further significant tightening of credit standards across all types of loan. The first chart below shows an indicator of corporate credit conditions derived from the survey. (It is an average of the percentage balances of officers reporting tighter standards on commercial and industrial loans to large / medium and small firms.) This indicator has warned of recessions historically by moving through 35. The latest reading is just below the “trigger” level.

The second chart plots the corporate credit conditions indicator together with a measure of the slope of the Treasury yield curve (the gap between the three-month Treasury bill rate and the average yield on bonds of over 20 years’ maturity). An inverted yield curve signals restrictive monetary conditions and is usually associated with a tightening of credit standards. The curve has been steepening recently, suggesting credit conditions could ease, though probably not until the second half of 2008.

The second piece of news was the ISM non-manufacturing survey for January, which reported shocking declines in current activity and new business. The third chart shows GDP growth with a weighted average of the ISM non-manufacturing new business and manufacturing new orders indices. The relationship is far from perfect but the ISM indicator suggests a contracting economy in early 2008.

Recent data have been weaker than I expected but a self-reinforcing downturn is not inevitable. Inventories are low, net exports should remain supportive and companies have yet to announce large-scale layoffs – see fourth chart. Loosening monetary conditions and fiscal stimulus suggest any decline will be short-lived and conditions will improve as the year progresses.

 

 

 

 

My MPC-ometer forecasts an “average interest rate decision” of -14 bp at this week’s MPC meeting. This is below the -12.5 bp threshold for action and suggests a 5-4 split in favour of a quarter-point cut.

As discussed in recent posts, the story is that activity indicators are firmly in rate-cutting territory but are being offset by the highest household and business inflation expectations since the MPC's inception.

A quarter-point reduction is expected by the overwhelming majority of economists. Interestingly, the Sunday Times Shadow MPC also voted 5-4 to cut.

Could the MPC surprise with a no change decision? In theory, the MPC-ometer’s -14 bp forecast would be consistent with five votes for unchanged, three votes for a quarter-point cut and one vote (presumably by David Blanchflower) for half a point. However, three-way splits on the MPC are rare (the last one occurred in May 2006), so I have discounted this possibility.