Benign liquidity conditions failed to prevent a sell-off in stocks last quarter as risk appetite deteriorated in response to ongoing credit market deterioration and an associated downward revision to expectations for economic activity and earnings.

The interplay of liquidity and risk appetite is illustrated by the chart below, showing “excess” money growth in the Group of Seven (G7) economies (i.e. the gap between annual expansion rates of the real broad money supply and industrial output) and a measure of risk aversion based on the VIX options volatility index. Stocks tend to perform well when excess money growth is positive and the risk measure is close to or below zero. Sharp rises in risk aversion neutralise or outweigh the impact of positive liquidity – in effect, the velocity of money falls and liquidity is temporarily “frozen”. Historically, however, periods of intense risk aversion rarely last more than about six months. The current episode is mature and recent additional official actions to stabilise credit markets may lead to a revival in risk appetite over the rest of 2008, allowing stocks to rally.

This assessment is subject to two caveats. First, the G7 excess money measure is biased upwards currently by “reintermediation”, i.e. the rerouting of financial flows through the banking system due to the collapse of off-balance sheet vehicles. One way of adjusting for this effect is to expand the monetary definition to include commercial paper used to finance such vehicles. This suggests “true” G7 excess money expansion of 4-5% rather than 6-7% – still significantly positive.

Secondly, while investor fear levels should abate, a return to risk-loving behaviour in equity markets is unlikely against the backdrop of slowing global economic activity and likely further downgrades to earnings estimates.

My ECB-ometer forecasts the monthly policy decisions of the European Central Bank based on 12 economic and financial inputs. The output is in the form of a projected interest rate change and may be thought of as the average recommendation of the 21 Governing Council members. Since the ECB moves official rates in quarter-point steps, a forecast of above +0.125% or below -0.125% is needed to generate a prediction of a policy change. The chart below shows historical performance.

Last month the model forecast was -0.10% – above the trigger level for a rate cut but suggesting economic and financial developments warranted an easing bias. There was no hint of any such bias in the policy statement delivered at last month’s press conference, which repeated the mantra about upside risks to price stability and a need to “monitor very closely all developments”.

This month the forecast has risen to -0.05%, implying economic and financial conditions are slightly less conducive to an early cut but still argue for some easing of the policy stance relative to recent ECB statements. The change since last month is mainly due to a further rise in inflation.

While there is little prospect of a cut next week, some adjustment to the policy statement is possible, involving a reference to increasing downside risks to growth to balance upside inflation risks. Barring such an adjustment, a reduction in rates in May, as suggested earlier, looks unlikely.

• Northern Rock’s borrowing from the Bank of England stood at £28.5 billion at the end of 2007, not £26.9 billion as widely reported. The larger figure includes £1.5 billion of funding obtained in the Bank of England’s open market operations (OMO) – probably the auction of three-month funds against a wider definition of eligible collateral conducted on 18 December.

• Movements in “other assets” on the weekly Bank of England Return suggest direct borrowing increased further in the first few weeks of the year, when Northern Rock’s future was in limbo. Rock may also have obtained additional OMO funding in a second auction of three-month funds on 15 January. So total support is likely to have peaked at about £30 billion, as seemed likely last autumn.

• Northern Rock’s restructuring plan shows government funding – excluding OMO loans – falling to just £1 billion by the end of 2009. This is consistent with the analysis here, indicating borrowing might be repaid surprisingly quickly.

• The Treasury is more cautious than Northern Rock about the repayment schedule. The Chancellor has set a deadline of the end of 2010 for full repayment and the Budget projected direct support at £14 billion at the end of the 2008/9 financial year. This caution may reflect doubts that other banks will be able to accommodate mortgage borrowers switching from Rock given the current difficult funding environment.

• The ability of other lenders to assume Northern Rock’s loans will depend partly on the nature and size of new longer-term financing facilities promised by the Bank of England to alleviate the funding crisis. The more generous the facilities, the more plausible Rock’s forecasts of rapid repayment will look.

• The penalty rate being paid by Northern Rock on its non-OMO borrowing appears to be one percentage point above Bank Rate. Note 28 to Rock’s accounts states that the margin above Bank Rate includes an “element of fixed PIK interest margin” (PIK = payment in kind, i.e. interest rolled up into a further debt). Note 34 gives a figure of £40.9 million for this PIK interest at the end of 2007. This interest accrued over the final four months of 2007. Assuming borrowing averaged £12 billion over this period, this would imply an annualised interest rate of about one percentage point ( 100 x ( 40.9 x 12 / 4 ) / 12000 ).

• The recent flow of cash back to Northern Rock, reflected in a fall in its Bank of England borrowing, has probably aggravated funding pressures faced by other banks, contributing to a rise in interbank interest rates. The Bank of England has cast doubt on such an effect, arguing that “the impact on the money markets of any flows of cash back to the Bank of England from Northern Rock is routinely offset in the Bank's weekly market operations.” This may miss the point, however. Banks suffering an outflow because of Northern Rock are unlikely to regard the weekly repo facilities as a substitute. The form in which official funds are supplied to the market is an important influence on interbank interest rates. The Bank has replaced a longer-term loan against mortgage collateral with short-term lending against government securities. Banks are struggling to secure long-term funding at present so the substitution is likely to have contributed to upward pressure on term interbank rates.