Late last year my US recession probability indicator rose to 45%, suggesting the economy would come close to but just skirt a downturn (as defined by the National Bureau of Economic Research).

Since then the credit crisis has intensified and soaring commodity prices have taken a further chunk out of real incomes. Most forecasters believe a recession has started and some expect it to be deep. Yet the data still leave room for debate.

Available evidence suggests GDP may eke out a small gain in the first quarter. Based on February numbers released today, personal consumption should be flat at worst. Housing investment will again be a significant drag but should be neutralised by stronger net exports. Other capex is likely to be little changed and stockbuilding should be positive. Annualised growth of 1% or so does not look out of the question.

A key reason for thinking a recession has started is a fall in private payrolls over the last three months. A further decline in March numbers released next Friday would be difficult to ignore but a rebound should not be ruled out. Weekly unemployment claims have yet to cross the 400,000 level to be expected in a serious labour market decline, while the excellent Trim Tabs point out that withheld tax receipts have picked up in recent weeks, suggesting conditions have at least stopped deteriorating.

Remember that fiscal policy is set to be a significant positive for the economy from May, when tax rebate cheques start to be mailed out.

The recent rise in interbank interest rates reflects a clash between expanding bank funding needs and a fixed level of longer-term Bank of England lending against private sector collateral – see yesterday’s post.

The pressure may, however, have been aggravated by a flow of cash back to Northern Rock .

Other banks benefited from Northern Rock’s woes last autumn, as savers withdrew funds from the troubled lender and redeposited them elsewhere. Now, the reverse flow is occurring, with savers lured back by attractive rates and government guarantees and Rock’s mortgage borrowers encouraged to refinance with other lenders.

Rather than lend its surplus cash back to other banks in the interbank market, Rock has reduced its borrowing from the Bank of England . The Bank of England weekly Return suggests the Rock loan has fallen from a peak of £27 billion in January to £21 billion currently.

The Bank of England should increase longer-term lending to the market to offset the liquidity drain from Northern Rock.

Why have interbank interest rates climbed sharply in recent weeks? The conventional view is that the increase reflects heightened concern about counterparty risk, partly due to the Bear Stearns crisis. However, an alternative explanation is that banks have exhausted the longer-term liquidity support provided by the Bank of England in tandem with other central banks around the turn of the year and are again scrambling to secure funding in the interbank market. This would suggest a need for a further expansion of such “lender of last resort” operations – a possibility now reluctantly being considered by the Bank of England.

The alternative explanation is supported by evidence that UK banks have continued to securitise and off-load loans in large volumes in recent months. According to Bank of England data, £29 billion of securitised lending to the UK private sector was removed from balance sheets in the seven months from August to February – only modestly down from £37 billion in the first seven months of 2007, before the financial crisis broke (see chart). Market demand for such paper has been non-existent since the summer. Instead, the securities are likely to have been used as collateral to obtain longer-term funding from the Bank of England and ECB.

The Bank maintained a strict definition of eligible collateral in the early stages of the crisis but relented to market demands and accepted triple-A-rated asset-backed securities in auctions to allocate £20 billion of three-month funds in December and January. This allowed banks to off-load their securitised paper and contributed to a sharp fall in term interbank rates in the first few weeks of the year. However, the relief has proved temporary as credit expansion has remained robust in early 2008, further boosting banks’ funding needs. The Bank is rolling over the December / January facilities but has not yet announced an increase in their size.

The gap between the £29 billion of securitised loans removed from balance sheets between August and February and the current £20 billion Bank of England limit on ABS collateral supports claims that UK banks have also been accessing ECB funds, either via Eurozone subsidiaries or by arrangement with facilitator banks. Indeed, the ECB may have been the first port of call given that it accepts collateral rated down to single A as long as securities are senior within the credit structure.

If the above explanation is correct, the Bank of England faces a difficult choice in responding to current market pressures. It can follow the recent example of the Federal Reserve and expand support operations significantly; as in December / January, this would probably be effective in lowering interbank rates but at the cost of a semi-permanent increase in banks’ reliance on official funding and associated “moral hazard” risks. Alternatively, it can refuse to bridge the funding gap created by continued solid lending growth, forcing banks to restrict credit availability further, with possibly major negative economic implications. In theory, the impact could be offset by cuts in official interest rates but achieving the right balance would be problematic, particularly against the backdrop of above-target and rising inflation.

The Fed influences the economy and markets by setting official rates and expanding or contracting its own balance sheet. Attention tends to focus on the former but balance sheet trends sometimes convey important additional information.

While the Fed slashed official rates in late 2007 and early 2008, Federal Reserve Bank credit – a key balance sheet measure – contracted. This suggested policy was not sufficiently expansionary to offset deteriorating economic and market trends.

The Bear Stearns crisis has forced the Fed to inject more cash – Fed credit jumped by $10 billion in the week to last Wednesday. An additional $20 billion was lent under the Term Auction Facility, $13 billion under the new Primary Dealer Credit Facility and $6 billion in connection with the J P Morgan-Bear Stearns transaction. The Fed partially offset these injections by selling $32 billion of securities from its own portfolio.

These changes have pushed the three-month growth rate of Fed credit to its highest since November – see chart. The Fed could yet sterilise recent and future cash injections, returning the balance sheet to its prior path. However, a continuation of the recent pick-up would be a strongly positive signal for economic and market prospects later in 2008.