“Other assets” on the Bank of England’s balance sheet have fallen in each of the last four weeks and are now £4.8 billion below a peak reached in late January. The most likely explanation for the decline is that Northern Rock is repaying its loan from the Bank as it enjoys a cash inflow from redeeming mortgages and savers attracted by its competitive rates and the unlimited government guarantee. If correct, this would support analysis suggesting Rock will pay back its loan much earlier than the three to four year horizon indicated in its business plan released this week (see here).

The Fed had announced a significant expansion of its liquidity support operations even before the Bear Stearns crisis broke. By contrast, aside from minor fine-tuning, the facilities offered to UK banks by the Bank of England have remained unchanged despite a steady climb in interbank rates in recent weeks, with three-month LIBOR fixing yesterday at 5.98%.

The Bank’s inertia reflects a view that interbank rates are rising because of heightened concern about counterparty credit risk rather than a shortage of liquidity. This is illustrated by a chart on page 11 of the latest Quarterly Bulletin (page 13 of the PDF), purporting to show that the liquidity or non-credit premium in current term spreads is negligible. Bank officials are therefore sceptical that expanding money market operations would have much impact; their inaction may also be informed by Mervyn King’s view that markets were previously underpricing risk so rising credit premia should not be resisted.

The flaw in this analysis is that credit risk and illiquidity are inextricably linked, as Paul De Grauwe argues on page 13 of today’s Financial Times. Northern Rock was and is solvent but its liquidity crisis resulted in significant losses for holders of its more junior debt. Market concerns that selected institutions will be unable to obtain funding are likely to have resulted in credit risk premia overshooting levels implied by solvency considerations.

Bank chiefs are reportedly meeting with Mervyn King today to ask for an expansion of liquidity support. That they have been forced to lobby publicly for such action suggests the Bank of England remains out of touch with markets and has failed to learn the lessons of Northern Rock.

1. The Fed has effectively pledged its own balance sheet to prop up markets. There is no limit to the cash the Fed can print and its solvency is guaranteed by the US government’s tax-raising authority.

2. Global liquidity is plentiful, with G7 broad money growth running at over 11% pa – a 26-year high. Investors are currently frozen in the headlights but will rush to deploy cash as it becomes clear that financial armageddon will be avoided.

3. Equity markets are discounting a recession – their performance since the current economic downswing began in September 2006 matches an average of six prior hard landings. Bears need to believe that a recession is not only certain but will be unusually severe.

4. A hard landing may yet be avoided. The impact of tighter credit is counterbalanced by a significant easing of monetary conditions and US fiscal stimulus worth over 1% of GDP, with tax rebates due to hit pay-packets from May.

5. Corporations have been cautious about expanding employment and investment in recent years and are not yet under strong pressure to retrench. Emerging world resilience is a further bulwark against a severe economic downturn.

6. Investor pessimism is extreme – the CBOE put / call ratio has spiked above levels at prior US market lows, including 1998, 2002 and 2003, while bears outnumber bulls by the widest margin since 1990, according to the American Association of Individual Investors. US-based equity mutual funds have suffered a $21 billion outflow so far in March, according to Trim Tabs.

7. While retail punters are bailing, US corporate insiders have stepped up buying, suggesting they see value in their shares and do not expect a wrenching recession. InsiderScore.com’s buy / sell ratio has surged well above levels at recent market lows – see here.

8. Losses on US subprime mortgages have been largely accounted for. According to S&P, write-downs on subprime ABS could reach $285 billion, of which well over $150 billion has been disclosed. The $285 billion estimate far exceeds projected credit losses of $136 billion on underlying loans, reflecting both the creation of synthetic subprime exposure and distressed pricing. For synthetic subprime, losses for some participants are balanced by gains for others, while write-downs due to distressed pricing should eventually be reversed.

9. The magnitude and duration of the fall in US financial shares is comparable with the decline associated with the savings and loan crisis of the late 1980s. Financials are now trading on a larger price-to-book discount to other sectors than at the 1990 trough.

10. The G7’s malign neglect of the dollar now represents the key risk for markets. The Fed’s excessive interest rate cuts coupled with ECB / BoJ intransigence have prompted a flight of capital out of the US, exacerbating financial stresses. An associated surge in commodity prices has undermined efforts to stimulate the economy.

My fears that the lack of a coordinated G7 response to worsening credit conditions and a tumbling dollar would push markets to a “riot point” appear to have been borne out by recent events, culminating in the sad demise of Bear Stearns.

To recap, the Fed’s panic rate cuts have been counterproductive in terms of restoring market stability, because they have triggered a flight of capital out of the dollar at a time when US financial institutions face severe funding difficulties. Other G7 central banks, led by the ECB, have contributed to the mistake by refusing to ease their own policies, thereby increasing pressure on the Fed and presenting dollar bears with an open goal.

Over the last 10 days the Fed has announced measures to provide an extraordinary $382 billion* of additional financial support – equivalent to 2.7% of annual GDP. Markets are also fully discounting a further 100 bp cut to 2.0% in the Fed funds rate target at tomorrow’s FOMC meeting.

The scale of this commitment should not be underestimated and there is little doubt that the Fed will take further action if required. The effects may, however, remain disappointing without a coordinated G7 effort to stabilise the dollar, involving policy rate cuts by the ECB and Bank of Japan and the Fed moving to the sidelines, at least temporarily.

_{* Breakdown as follows: increase in Term Auction Facility $40 billion, increase in conventional term repos $100 billion, new Term Securities Lending Facility $200 billion, increase in foreign exchange swaps with other central banks $12 billion, special facility provided to J P Morgan related to acquisition of Bear Stearns $30 billion.}