The Bank of England may have increased its foreign currency lending to banks, judging from the latest weekly Bank Return.

The Bank’s Annual Report, published on 14 July, revealed a rise of £8.2 billion in its foreign currency lending to banks in the year to the end of February, financed by borrowing from other central banks – see here for more details. This may have reflected a “covert” support operation similar to the swap arrangements between the Fed and the ECB and Swiss National Bank, under which the latter have borrowed dollars for onlending to banks in Europe.

According to the weekly Return, the Bank’s “other assets” – comprising mainly foreign currency assets and the loan to Northern Rock – jumped by £2.9 billion in the week to Wednesday, reaching their highest level for seven weeks. With Rock repaying its debt as its mortgage borrowers refinance their loans elsewhere, the increase may reflect an expansion of the Bank’s foreign currency lending.

The various additional liquidity support measures announced by the Fed this week included a temporary increase in the ECB’s swap facility from $50 billion to $55 billion to accommodate an extension of the term of loans offered to banks in Europe from 28 to 84 days. This suggests demand for dollars by European banks remains strong, partly reflecting a need to fund dollar assets transferred from off-balance-sheet conduits and SIVs.

Recent monetary developments have been worrying, with underlying M4 growth (i.e. excluding money holdings of certain financial intermediaries) slowing sharply and the corporate liquidity ratio falling to a 17-year low. However, some comfort can be drawn from stable household sector money trends.

The chart shows annual growth rates of consumer spending and two measures of household real money – overall M4 and non-interest-bearing M1 (i.e. currency holdings plus interest-free sight deposits). The consumer recessions of the mid 1970s, early 1980s and early 1990s were associated with annual falls in one or other measure. However, both are still growing solidly currently.

This resilience may not persist but household money trends are not yet consistent with a sustained contraction in consumer spending.

The inflation surge of the 1970s is widely acknowledged to have been caused partly by insufficiently restrictive monetary policies following the 1973 oil “shock”. Are policy-makers similarly at risk of “accommodating” the inflationary impact of higher commodity prices now, as they simultaneously seek to minimise economic weakness caused by credit market woes?

The rise in oil prices in recent years has occurred in two distinct stages, which mirror the two shocks of the 1970s, although the primary driver has been emerging world demand for energy rather than supply disruption. The initial breakout from the range of the prior decade occurred between late 2003 and mid 2005, when prices rose from $35 to $65 a barrel (expressed in terms of today’s US consumer price level). A period of stability then ensued until early 2007, when prices embarked on a further surge to their recent peak above $140. For comparison, inflation-adjusted prices rose from $13 to $45 during the 1973 oil shock (caused by an Arab embargo on supplies to allies of Israel) and from $45 to a peak above $110 in 1978-79 (as the overthrow of the Shah led to sharp fall in Iranian exports).

A simple way of measuring the monetary policy response to an oil price change is to compare subsequent movements of short-term interest rates and headline consumer price inflation. As the chart below shows, average G7 short rates failed to keep pace with inflation following the 1973 shock – real rates were consistently negative over 1974-78. This policy response is now recognised to have been misguided: it allowed higher inflation expectations to become entrenched and did not avert a severe recession. By contrast, short rates were raised well above the level of inflation after the second shock of 1978-79, partly under the influence of hawkish US Fed Chairman Paul Volcker. Recession again ensued but the restoration of monetary discipline laid the foundations for a sustained decline in inflation during the 1980s.

How does recent experience compare with these episodes? The 2003-05 oil price rise was less dramatic than the 1973 shock and had a much smaller impact on headline inflation. As the chart shows, G7 short rates moved up in line during the shock and became significantly positive in real terms in 2006 as inflation fell back. On this basis, policy appears to have been broadly appropriate, although the Fed should arguably have been swifter to tighten in 2004-05 – low real rates contributed to the subsequent housing market bubble. The response to the more recent oil price surge has been less convincing. The Fed’s decision to prioritise credit market concerns and ease policy aggressively coupled with a larger rise in headline inflation than in 2003-05 has resulted in G7 real short rates becoming significantly negative. As in the mid 1970s, it is debatable whether policy laxity has served the intended purpose of supporting activity and it may have contributed to an unwelcome rise in inflation expectations.

It is possible to argue that G7 monetary policies are tighter than suggested by the level of real short rates because of the impact of the credit crisis on banks’ lending behaviour. However, the interest rate measure used in the chart is based on interbank rather than policy rates so partly incorporates current market dislocation. Moreover, any assessment of the global monetary stance must also include emerging economies, where banks are generally still lending freely and short rates are even further below inflation. Taking these considerations into account, there appears to be little scope for any early decline in global rates if inflation is to be returned to the low levels of the last decade. Indeed, a rise may be required – led by the US and emerging economies where real rates are heavily negative – to ensure sufficient monetary discipline.

M4 and M4 lending jumped sharply in June but the increases were largely due to “other financial corporations” (OFCs) and may reflect distortions caused by the Bank of England’s special liquidity scheme. Excluding OFCs, M4 rose by 6.4% in the year to June, the lowest annual growth rate since 2000 – see first chart.

Corporate liquidity trends are particularly concerning: M4 holdings of private non-financial corporations (PNFCs) fell for the fourth consecutive month, while their liquidity ratio (cash divided by bank borrowing) slumped to a new 17-year low, with negative implications for future business spending – see second chart.

This is not a time for hawkish heroics. The MPC should hold rates at next week’s meeting and be prepared to ease later in the year if these money trends continue.

Contrary to consensus expectations, the US has held up better than other major economies since the credit crisis erupted last summer.

The first estimate of US second-quarter GDP is released on Thursday. According to Reuters, economists expect quarterly growth of 2.0% annualised (I think a stronger number is likely). If realised, this would imply a year-on-year increase of 2.1%.

Available evidence suggests the Eurozone and Japanese economies contracted in the second quarter, partly as pay-back for exaggerated strength in the first three months. Assume optimistically that GDP is unchanged on the quarter in both cases. This would imply year-on-year growth of 1.7% and 2.0% respectively.

UK second-quarter numbers released on Friday showed year-on-year GDP growth of just 1.6%.

Stopped-clock pessimists now expect a US recession to start during the second half. They will be right one day but I expect the economy to stay afloat, based on loose policies and low inventories – likely to have fallen further in the second quarter. Downside risks look much greater in Europe.