Monday’s post expressed concern about a recent sharp deterioration in business and consumer surveys. The February Philadelphia Fed survey of regional manufacturers, released yesterday, was another shocker, with the expected new orders index plunging into negative territory – a rare occurrence. As the chart below shows, this suggests further weakness in the national ISM survey to be released on 3rd March.

This morning’s “flash” Eurozone purchasing managers’ surveys were more reassuring, however, with the manufacturing new orders index only slightly lower than in January and the services new business index recording a surprise recovery. It could be that the Eurozone surveys are proving slower to pick up emerging economic weakness but it is also possible that the slide in US confidence has been exaggerated by the Fed’s panic rate cuts, which suggested the central bank believed a recession had started.

The Philadelphia Fed survey does not resolve the recession issue. The expected new orders index has fallen below zero on five previous occasions since the survey’s inception in the late 1960s. In four of the five cases a recession followed but in two of these it began more than a year later. In one case – 1995 – the economy skirted recession.

Nor is the survey’s weakness necessarily a signal of further equity price falls ahead. In the five prior instances of expected new orders turning negative, the average change in the S&P 500 index over the subsequent six calendar months was +8.8%. The change was positive in four of the five cases, the exception being 1973 – but this was in the context of the orders index continuing to plunge to a record low of -43.

What are the implications of the continuing surge in commodity prices?

The first implication is that there is no shortage of global liquidity available to chase a “hot” investment theme. This is consistent with the current large gap between G7 real broad money supply growth and industrial output expansion – see chart. As I have argued previously, this gap is helping to cushion the effect of credit tightening on economies and markets.

Secondly, the commodity surge supports my view that Fed easing has been counterproductive, serving to boost inflationary risks rather than stimulate the real economy. The Fed should have waited for inflation expectations and commodity prices to soften before cutting rates aggressively.

Thirdly, the squeeze on G7 real incomes implied by rising commodity costs will sustain current economic weakness. However, I still think a recession / hard landing can be avoided and momentum will improve later in 2008 as looser monetary conditions offset credit tightening. More on that soon.

Last week’s Inflation Report was regarded as slightly hawkish but I was struck by the forecast based on unchanged interest rates, showing an annual CPI increase of just 1.77% in the first quarter of 2010. Despite two rate cuts and a sharp fall in sterling, this was only 3 bp higher than the two-year-ahead forecast in November’s Report and represents the second largest shortfall from target in the MPC’s history.

The message was reinforced by today’s minutes of the February meeting, showing an 8-1 vote in favour of the quarter-point cut, with David Blanchflower dissenting in favour of a 50 bp move. This is considerably more dovish than the 5-4 split suggested by both my MPC-ometer and the Sunday Times Shadow MPC.

In light of this information, and ongoing deterioration in credit markets, I now expect an early further cut in rates despite the prospect of a surge in CPI inflation to 3% by the third quarter of 2008. I will be guided by the MPC-ometer but a move seems likely before the next Inflation Report in May.

My personal view is that rates should be held at 5.25% until inflation is over its hump. The MPC’s mandate is to meet the 2% target “at all times” not just at the two-year horizon. It is true that its policy actions have a negligible effect on near-term inflation prospects but they are relevant one year ahead, when the Inflation Report suggests the annual CPI increase will still be well above target, at 2.29%.

Media comment has focused on the risks but the nationalisation of Northern Rock could prove extraordinarily profitable for UK taxpayers – assuming the government can avoid making a significant compensation payment to equity and subordinated debt holders.

Despite Treasury guarantees, Northern Rock has been forced to offer high interest rates to retain its retail deposit base, with savers concerned that their accounts would be frozen in the event of the bank going into administration. (Including a temporary loyalty bonus, Rock’s tracker online account currently pays a 6.99% AER.) Nationalisation removes this liquidity risk and should allow the bank to reduce its retail funding costs significantly.

European Union state aid requirements imply the Bank of England will continue to charge a penal interest rate on its loan but this now represents a transfer within the public sector.

On the assets side, the aim will be to shrink the mortgage book to allow early repayment of the Bank of England’s loan. New lending will be negligible and mortgage rates will be raised to encourage existing borrowers to refinance elsewhere. Assuming they stay, this will add to the boost to profitability from lower funding costs. Job losses are also inevitable, reducing the bank's cost base.

The key concern is that housing market weakness coupled with possible adverse incentive effects from public ownership will lead to significant default losses. Northern Rock had £97 billion of customer loans at 30 June 2007 but credit risk on £46 billion of the total had been partially transferred to holders of securitised notes.

In the housing recession of the early 1990s repossessions nationally reached a peak of 0.77% of outstanding mortgages in 1991. Assume Northern Rock is forced to foreclose on 1% of its loans each year for three years and achieves a recovery rate of only 70%. Based on a £97 billion book, this would imply a loss of £850-900 million, of which about £150 million might fall on holders of securitised notes. Northern Rock’s shareholder funds stood at £2.3 billion at 30 June 2007. Even assuming significant erosion since, the remaining equity in the business should easily absorb any losses barring an Armageddon scenario for the housing market.

A large divergence has recently opened up between survey-based measures of economic activity and “hard” data released by official statistical insitutions.

The hard information has been holding up reasonably well, examples last week including US retail sales and industrial output and Japanese and Eurozone GDP. As the first chart below shows, G7 industrial output growth has been following my soft landing scenario closely.

Surveys, by contrast, have deteriorated sharply over the last month, in some cases to an extent suggesting recession. For example, the earnings revisions ratio from the IBES survey of equity analysts plunged to a seven-year low in February – see second chart. Marked weakness was also on display in reports last week on US consumer sentiment, US small firm optimism, Japanese consumer confidence and German investor sentiment.

Under normal circumstances survey-based information provides a useful lead on hard economic data. However, sentiment weakness may have been exaggerated by negative credit market news and the Fed’s “emergency” rate cuts, which suggested the central bank expected a recession.

I am inclined to give greater weight to the hard data but will be concerned if the deterioration in sentiment is sustained and confirmed across a wider range of surveys. In the Eurozone, this week’s “flash” PMI readings will provide an important litmus test.

The extent of near-term global economic weakness is unclear but I still expect an improvement later in 2008 as recent monetary loosening offsets tighter credit conditions.