The CB Richard Ellis measure of prime commercial property yields rose further to 6.2% in the second quarter, up from 4.8% a year before and close to the 6.4% average over 1972-2007.

Using the raw yield to assess valuation is problematic because rents fluctuate significantly with the economic cycle. A high yield may not indicate that property is cheap if rents have been boosted above a sustainable level by a buoyant economy. Conversely, it may be right to invest when yields are low if rents are below trend and likely to benefit from future strong economic growth.

Based on their long-term relationship with GDP, I estimate rents are about 5% above trend currently – see first chart. There were much greater deviations in the early 1970s and late 1980s, when rents overshot by 30-40%. This implies a normalised or cyclically-adjusted yield of 5.9%.

Any judgement about valuation should also take account of returns on competing assets. The rental yield is often compared with yields on conventional gilts but this is invalid because bond interest is fixed while rents rise with inflation over the long run. In other words, the rental yield should be compared with real not nominal interest rates.

The second chart below updates my comparison of the normalised rental yield with real yields on long-term index-linked gilts. The gap between the two has surged from 3.1% in last year’s second quarter to 5.1% currently – the highest since 1994 and well above a long-term average of 3.6%.

Tight credit conditions and a weakening economy should lead to a further fall in demand for property space and rents are likely to undershoot their trend level over coming quarters. Current valuations already discount much gloom, however.

Like its MPC counterpart, my ECB-ometer has shifted in a dovish direction over the last month. The model suggests a 33% probability of a cut in rates at tomorrow’s meeting, compared with a 55% chance of a hike last month – see chart.

The swing reflects a combination of: very weak business and consumer surveys; slower M3 growth; a fall in short-term bond yields; and the less hawkish policy statement issued after last month’s meeting. These factors have offset a further slight deterioration in inflation indicators.

The model is consistent with a peak in official rates but it will take several more months of data to confirm this scenario.

The £9.4 billion reduction to £17.5 billion in net borrowing from the Bank of England during the first half is consistent with projections made here in March (see Northern Rock: BoE payback could occur sooner than expected ) and reflects the huge scale of mortgage repayments by Rock’s borrowers.

During the first half of 2007, Rock accounted for £10 billion of the £54 billion increase in UK net residential mortgage lending. During the first half of this year, UK lending slumped to £30 billion, while Rock borrowers repaid £13 billion. In other words, Rock’s U-turn accounts for £23 billion of the £24 billion fall in UK-wide lending between the first halves of 2007 and 2008.

Rock’s rapid shrinkage has exacerbated the wider mortgage market squeeze, with negative macroeconomic implications. (See Northern Rock: should Sandler slow down?)

Barring a change in policy, Rock’s loan (to be switched to the Treasury from the Bank of England) should continue to fall rapidly during the second half, ending the year well below £10 billion. Mortgage repayments should remain high: documentation on loans within the Granite pool suggests the number of fixed-rate agreements expiring during the second half will be similar to the first six months. Retail deposit inflows should slow but Rock may repay less non-official wholesale borrowing than in the first half.

With the Treasury planning to swap £3 billion of the Bank of England debt for equity, the loan portion of the outstanding balance could be down to £5 billion by year-end.

The transfer of the Rock loan from the Bank of England to the Treasury will have an initial negative impact on the money supply, to the extent that additional gilts issued to finance the transfer are purchased by the UK non-bank private sector, with payment made from existing bank or building society deposits. A £17.5 billion reduction in such deposits would cut broad money M4 by 1.0%.

My MPC-ometer suggests several MPC members will join David Blanchflower in seeking a cut in rates this month but will be outvoted by a slim majority in favour of no change.

The model results are consistent with either 5-4 (four votes for a 25 bp cut) or 6-3 (two votes for 25 bp with DB seeking a 50 bp cut).

The forecast is more dovish than market expectations and reflects recent very weak economic news, which has counterbalanced adverse inflationary indicators.

Interestingly, the Sunday Times Shadow MPC result was also dovish this month, with three members voting for an immediate cut and four others with an easing bias.

Meanwhile, annual growth in the Bank of England’s adjusted M4 measure – which excludes money holdings of certain financial corporations that act mainly as a conduit for interbank business – fell further from 8.8% in March to 8.0% in June, according to figures released this morning. This is the lowest since 2004 and compares with an 11.4% annual increase in headline M4 – see chart. Monetary trends now appear to be consistent with inflation returning to target over the medium term. (Post-ERM experience suggests adjusted M4 growth of 6-8% pa is consistent with 2% CPI inflation – see here.)