As detailed in previous posts (e.g. here), my US recession probability indicator peaked just below the 50% “trigger” level in late 2007. The suggestion was that the economy would be very weak in late 2007 / early 2008 but would just skirt a contraction, as defined by the official arbiter, the National Bureau of Economic Research (NBER).

Two months ago 76% of economists surveyed by the Wall Street Journal believed a recession had started. A new survey published today showed the percentage down to 52%, reflecting recent better-than-expected data.

The NBER places particular emphasis on five indicators in determining whether and when a recession has started: GDP, personal income, employment, industrial output and business sales. GDP is regarded as the single best measure but official figures are available only quarterly. Of the four monthly indicators, the NBER assigns greater weight to personal income and employment because they cover the whole economy rather than just the goods sector.

GDP is currently estimated to have grown at annualised rates of 0.6% and 0.9% respectively in the fourth and first quarters. However, these figures could change significantly when annual revisions are published next month. So it is important to track the other four NBER indicators in judging the likelihood of an official recession determination.

The chart below compares recent movements in a composite index of the four indicators with its behaviour during the last seven NBER-defined recessions. The index is derived by rebasing each indicator to equal 1 in the month of a NBER cycle peak and calculating a weighted average. Reflecting their whole-economy coverage, personal income and employment are assigned a 30% weight versus 20% for industrial output and business sales. The current cycle is measured from October 2007 – the latest peak month for the composite index.

The minimum peak-to-trough fall in the index during the last seven recessions was 1.6% (in 2001). It is reasonable to assume this threshold must be reached for the NBER to call a recession now. As at April, the decline from October stood at 0.6%. So the index is consistent with the message from the latest GDP estimates – the economy is not yet sufficiently weak to warrant a recession determination.

My recession probability indicator is giving an “all-clear” signal for late 2008, based on falls in real interest rates and a steeper yield curve, which are judged to outweigh tighter credit conditions. It may be underestimating the negative impact of recent further energy price gains but I continue to expect the US economy to perform better than many fear in 2008, with greater risk of disappointment in Europe. 2009 may be another story, however.

May consumer prices figures are published on Tuesday but Bank of England Governor Mervyn King will already know whether the annual increase reached the 3.1% letter-writing level. Recent news suggests it did, which may explain the lack of any discussion of monetary policy in Mr. King’s speech to the British Bankers Association this week.

Producer output prices accelerated further in May but the aggregate PPI is not generally a good short-term guide to CPI movements. However, the PPI food component correlates closely with consumer prices of processed food and showed a further large rise last month – see chart. If reflected in the CPI, this would add an estimated 0.12 percentage points to the annual increase – sufficient to reach 3.1% assuming no other changes.

Energy prices will have a further upward effect. Electricity and gas prices fell by 2.1% in May 2007 but should have been stable this May, adding 0.07 percentage points to CPI inflation. Meanwhile, the price of unleaded petrol rose by 4.5 pence per litre against a 3.1 pence increase last May, according to the AA, suggesting a further boost of 0.04 pp.

Recent sterling weakness is another possible source of upward pressure. Manufactured import prices rose a further 2% in April to stand 7% above their level in the fourth quarter of 2007.

A 3.1% CPI reading is not a done deal – “core” inflation jumped sharply in April and may partially retrace the increase in May. It would surprising if the decline were sufficient to offset the above upward effects, however.

Markets are now discounting two quarter-point rate rises in the UK over the next year. While I have been more bearish than the consensus about interest rate prospects, I think a retightening of policy would be a mistake and is unlikely to occur.

The foundations of the current inflationary upsurge were laid in 2005-2007, when the broad money supply M4 was allowed to grow at a 12-13% annualised rate. To return inflation to the 2% target over the medium term, the rate of M4 expansion needs to be brought down to 6-8% pa. However, the slowdown should be gradual – a collapse in money growth would risk transforming a painful economic adjustment into an unnecessary bust.

M4 was still rising at an annual rate of 11.1% in April but has been inflated by financial transactions related to the credit crisis – see here. An adjusted measure proposed by the Bank of England grew by 9.0% in the year to March (the latest available month) and at an annualised rate of just 4.8% in the first quarter alone.

This slowdown is contributing to a dangerous liquidity squeeze on companies. Annual growth in M4 holdings of private non-financial corporations (PNFCs) has slumped from a peak of 16.1% last May to 1.0% in April. Relative to retail prices, real PNFC M4 is contracting at the fastest rate since the early 1990s, suggesting a growing risk of a slump in business spending – see chart.

With inflation and inflation expectations rising, the MPC has little choice but to sit on its hands for the foreseeable future. However, the Committee should resist pressure to compensate for its poor decisions in 2005 and 2006 by adopting an unduly restrictive policy stance now.

Bears were cheered by the latest US labour market report, showing a jump in the unemployment rate to 5.5% in May. On closer inspection, however, much of the rise was due to an expansion of numbers seeking work, particularly among people aged 16-24. (The unemployment rate for this group jumped from 11.0% to 13.0%; some reversal is likely next month.)

Employment trends are more relevant for assessing economic growth. Two measures are reported – one based on payrolls and the other on a survey of households (from which the unemployment rate is derived). Payroll employment has been falling since December but the household survey measure has been broadly stable – see first chart. The rate of decline of payrolls has been lower than during the 2001 and prior recessions. Allowing for productivity growth of about 2% annualised, recent developments remain consistent with GDP expansion, albeit sluggish.

Export strength, particularly to the emerging world, continues to support the US economy – the export orders index in the ISM manufacturing survey hit a four-year high in May. The second chart shows industrial output growth in the “E7” major emerging economies together with a composite leading index based on OECD data. (The OECD does not publish a leading index for Taiwan so the national index has been used instead.) Output rose by an estimated 9% in the year to April, which compares with sub-1% growth in the G7. The leading index suggests a  further slowdown over coming months but remains notably stronger than during prior global economic downswings.

As discussed in the last post, inflationary pressures are forcing monetary policy tightening in emerging economies. However, interest rates are currently below a “neutral” level in many countries and in some cases attempts to tighten are being frustrated by an expansion of liquidity due to currency inflows. (China’s foreign exchange reserves rose by $78 billion in April alone.) Policy restriction will eventually lead to a significant slowdown in the emerging world but this is probably a story for 2009-2010 rather than this year.

The further surge in oil prices is casting a cloud over prospects but the evidence to date is that the US and global economies continue to hold up better than most economists expected.