Broad money supply and credit numbers have been boosted by the financial crisis and the Bank of England’s special liquidity scheme (SLS) has increased the distortion.

The money supply effect is the result of banks cutting back on traditional unsecured interbank lending in favour of various forms of secured loans. These secured loans are typically channelled through non-bank financial institutions, often bank subsidiaries, whose transactions are included in M4 and M4 lending.

The money holdings and bank borrowing of these “intermediate other financial companies” – to use the Bank of England’s terminology – have no implication for spending on goods and services and should be removed from the data for the purposes of monetary analysis. The effect is similar to “roundtripping”, which occurred in the 1980s when non-financial companies took advantage of interest rate anomalies to borrow from banks and redeposit the funds at a higher rate.

The distortion has increased since the introduction in April of the SLS, which has expanded the available pool of high-quality collateral against which banks can borrow and lend.

Headline M4 and M4 lending rose by 11.2% and 13.5% respectively in the 12 months to June. Stripping out intermediate OFC flows, the growth rates fall to 6.5% and 9.4%, according to the Bank of England.

In the second quarter alone, when the SLS was in operation, headline M4 grew at a 11.7% annualised rate but the adjusted measure is estimated to have risen by just 3%.

The level and pace of slowdown of adjusted M4 growth warrant consideration of an interest rate cut but the MPC is constrained by high and rising inflation expectations, sterling weakness and fiscal laxity, likely to be confirmed by the coming Pre-Budget Report.

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Is the economy now contracting?

A composite indicator based on activity and orders indices from the purchasing managers’ surveys is at a level suggesting a small decline in GDP in the third quarter. However, the surveys extend back only to the early to mid 1990s, so their history does not encompass a full recession, implying uncertainty about the relationship. Moreover, the latest results, for July, were probably depressed by a surge in energy prices, which has since reversed. An alternative coincident indicator with a long history and a good record of signalling economic contractions is the rate of change of job vacancies. Quarterly GDP falls have historically been associated with a three-month decline of over 10% in the stock of vacancies. The three-month change in July was -8%, suggesting a stagnant or very slowly growing economy.

What is the risk of a full-blown recession?

In the recessions of the mid 1970s, early 1980s and early 1990s, the annual change in GDP bottomed at -2.7%, -4.1% and -2.1% respectively. Forward-looking indicators have yet to signal comparable weakness. For example, a monetary forecasting model – with inputs including interbank rates, credit spreads, narrow and broad money supply growth and the effective exchange rate – projects a fall in annual GDP growth to about 0.5% by the first quarter of 2009 (see chart). Based on the model’s forecasting error, this implies a 30-40% probability of a recession – defined as an annual fall in GDP – in the first quarter. The MPC’s latest forecasts are similar but slightly more downbeat: annual GDP growth is projected at 0.1% and zero respectively in the first and second quarters of 2009 assuming unchanged interest rates, consistent with an evens chance of a recession.

How do current conditions differ from prior cyclical downturns?

In terms of the monetary model, there are three contrasts with prior pre-recessionary periods. First, the interest rate “shock” suffered by the economy has been smaller. In the two years before the onset of the last three recessions, the three-month interbank rate rose by an average of 680 basis points; in the last two years the increase has been 120 b.p. Of course, some households and firms seeking to raise new funds have experienced a larger rise but interest rate changes affect the economy partly via their impact on the debt servicing burden and disposable income of existing borrowers: the average rate paid on the stock of outstanding mortgages has increased by only 50 b.p. over the last two years. Secondly, narrow money typically contracts in real terms before recessions but is currently still growing: non-interest-bearing M1 – currency plus interest-free sight deposits – rose by an annual 7.3% in June. Thirdly, the effective exchange rate has fallen by 11% over the last year versus an average 1% rise in the year before the last three recessions.

Will the economy recover later in 2009?

The MPC’s forecasts show annual GDP growth recovering from zero in the second quarter of 2009 to 1.0% by the fourth quarter, reflecting easier credit conditions, a diminishing drag from higher energy costs and a boost to net trade from the lower pound. The monetary model forecasts only to the first quarter based on current data but can be used to project further ahead assuming no change in the inputs; this also suggests a revival in annual growth. However, risks lie on the downside – the inputs may deteriorate, with monetary expansion, in particular, likely to slow further, possibly significantly.

Will inflation return to target within two years?

Base effects will be significantly favourable for headline inflation during 2009. If energy and food prices fall back, a return to 2% or even below is possible by late next year. However, the medium-term outlook will be shaped by “core” developments. Annual CPI inflation excluding fresh food and energy rose to an MPC-era high of 2.6% in July and is likely to climb further for three reasons: pass-through of recent cost increases, continuing sterling weakness and earlier monetary excess. The lower exchange rate is lifting core inflation partly via higher non-commodity import prices – manufactured import costs rose an annual 7% in June, having been unchanged in the previous 12 months – but also by reducing competitive restraints on domestic firms’ price and wage decisions. Monetary trends influence inflation with a variable lag averaging two years. Adjusted for financial distortions, broad money growth peaked in the second quarter of 2007 and is now slowing sharply, suggesting inflation relief in the second half of 2009. However, any decline may be insufficient to reverse the earlier increase and return core inflation to 2% in two years.

Will the MPC cut official rates significantly?

Aside from its own forecast uncertainties, the MPC is constrained by three factors. First, Bank Rate at 5.0% is low relative to current inflation and – more importantly – inflation expectations. According to the latest NOP / Barclays Basix survey, households expect inflation to stand at 4.8% in five years’ time. Cutting the policy rate below public inflation forecasts would risk damaging the MPC’s inflation-fighting credibility, with negative longer-term repercussions. Secondly, reductions in UK rates unmatched by a similar move overseas – as implied by current market expectations – could exacerbate sterling weakness, thereby extending the overshoot in core inflation. Thirdly, the coming Pre-Budget Report is expected to deliver further fiscal stimulus, which – together with cyclical deterioration – may push public net borrowing up to 4-5% of GDP next year. Fiscal slippage further raises the risks to credibility and sterling if monetary policy is loosened substantially.

One way of assessing the downside for house prices is to ask how much further they would need to fall to achieve either a “fair” level by historical standards or a given level of undervaluation – on the assumption that markets typically undershoot on the way down.

The discussion is usually couched in terms of the house price to earnings ratio but – as explained in an earlier post – the rental yield on housing is a superior measure of valuation.

The chart below shows historical National Accounts data on the rental yield together with a current estimate based on prices having fallen 11% from their peak late last year (as suggested by the Halifax index).

The current estimated yield of 3.4% compares with a long-term average of 3.6% – a reasonable estimate of “fair value”. Assuming no change in rents, prices would need to fall a further 6% to bring the yield up to the average. The RICS survey of letting agents released today indicates that rents are still rising so a smaller decline would be possible.

Now suppose the market undershoots to the same extent that it overshot in 2007. The yield got down to 2.9% last year – 70 basis points below the average. A rise to 70 b.p. above the average would take it to 4.3%. This would involve a further 21% fall in prices from current levels, assuming unchanged rents.

The bottom line? A further 10-20% fall in prices would bring them to an attractive level for a long-term owner or investor.

The consensus expects US GDP growth to slow sharply from a currently-reported 1.9% annualised gain in the second quarter (likely to be revised up significantly next week), reflecting an unwind of tax rebate stimulus. I am more optimistic based on the lagged impact of Fed easing, energy price relief, the stocks cycle, a diminishing drag from housing construction and ongoing trade improvement.

There were glimmers of hope in business and consumer surveys last week. The first of the regional manufacturing surveys released for August – from the New York Fed – reported a significant recovery in expectations for future activity – see first chart. If confirmed by this week’s Philadelphia Fed survey, this could presage an improvement in the national ISM survey over coming months.

Meanwhile, the early August national consumer survey conducted by the University of Michigan showed a further recovery in household perceptions of the housing market: the percentage balance of respondents judging the present to be a good time to buy a home rose to a three-year high – see second chart. However, an increase in mortgage rates following the financial crisis at Fannie Mae / Freddie Mac may delay any impact on activity.