A major investment bank believes UK banks will have tapped the Bank of England’s special liquidity scheme to the tune of over £200 billion by the time the drawdown period ends in October. To put this into context, £200 billion is the equivalent of 14% of annual GDP or 6% of banks’ and building societies’ total sterling liabilities.

According to the interim Crosby report on mortgage finance, outstanding UK residential mortgage-backed securities and covered bonds totalled £257 billion at the end of last year. The Financial Times reported in May that banks had created almost £90 billion of additional securities for use under the scheme. So there is sufficient paper available for the £200 billion estimate to be plausible.

However, it is difficult to find corroborating evidence of activity on this scale from Bank of England data on banks’ assets and liabilities. Banks obtaining Treasury bills under the scheme would be expected to use these as collateral for increased repo borrowing. Yet official data show a fall in banks’ repo liabilities of £33 billion between March and July.

It is likely that banks are channelling their SLS activities through off-balance-sheet entities. Such entities were previously used to issue RMBS to the market, with the proceeds routed back to the related bank. They may now be borrowing in the repo market using Treasury bills obtained under the SLS, again on behalf the parent bank. Consistent with this hypothesis, “intermediate other financial companies” increased their deposits with UK banks by an estimated £38 billion in the second quarter. As argued previously, this has resulted in a major upward distortion to M4 money supply growth.

If confirmed, would SLS take-up of £200 billion imply a significant beneficial impact on UK banks? To the extent that the scheme allows banks to avoid a step-up in funding costs when existing wholesale borrowing matures, the effect is to prevent further damage rather than provide a positive benefit. However, it should also have allowed some banks to reduce their average cost of funds.

The scheme is generating significant profits for the authorities. The fee charged on borrowings of Treasury bills is the spread between three-month LIBOR and the three-month general collateral gilt repo rate – currently 70 bp. Assuming an average spread of this level in the first year, and borrowing of £200 billion, the Bank of England would earn £1.4 billion from operating the scheme. This is a multiple of the income the Bank generates annually from its main revenue source, the system of cash ratio deposits, under which banks are required to hold a proportion of their eligible liabilities in a non-interest-bearing deposit at the Bank. SLS profits will presumably be remitted to the Treasury.

Unsurprisingly, my MPC and ECB models signal no change in rates at today’s meetings but both are consistent with an easing bias.

The MPC-ometer suggests either a 5-4 vote for unchanged rates (four votes for a 25 bp cut) or 6-2-1 (two votes for 25 bp, one vote for 50 bp – no prizes). Key contributors to the dovish forecast are the downward revision to second-quarter GDP, a fall in price expectations in the EU consumer survey and lower short-term gilt yields. Partially offsetting these factors are the weak exchange rate and higher share prices.

One caveat: the actual vote has been less dovish than the model’s predictions recently. However, historically it has sometimes been early in picking up shifts in the MPC’s thinking.

For comparison, the Sunday Times Shadow MPC has voted 7-2 for unchanged rates (two votes for a 50 bp cut).

The ECB-ometer, which signalled July’s 25 bp rise, is now suggesting a one-third chance of a cut. Factors contributing to the dovish swing include weak business and consumer surveys, a slight decline in inflation, slowing M3 growth and a fall in short-term bond yields.

With policy tightened only two months ago, officials are understandably reluctant to concede that incoming data now warrant an easing bias. However, there may be some minor changes to the language in today’s policy statement to the effect that either upside inflation risks have diminished slightly or – more likely – downside growth risks have increased.

The first revision to second-quarter GDP, published on Friday 22 August, downgraded growth from the first quarter from 0.2% to zero. According to press reports, this was the weakest performance since the second quarter of 1992 – the tail-end of the last recession.

Such statements are wrong because they compare the first revision to the latest quarter with final GDP estimates for prior quarters. In fact, there were three quarters after 1992 for which the first revision indicated no growth in GDP – the first quarter of 1999, the fourth quarter of 2001 and the first quarter of 2002. The latest data shows GDP increases of 0.4%, 0.4% and 0.5% respectively for the three quarters. Clearly, there is a significant chance that the current second-quarter number will be revised higher.

The OECD yesterday published forecasts showing GDP declining at annualised rates of 0.3% and 0.4% in the third and fourth quarters, satisfying one definition of a recession. However, the OECD quotes a standard error of 1.2% around its projections, implying the forecast declines are not statistically significant. Moreover, according to a footnote, the UK model has been revised to include residential property prices, which are thought to be important currently, but the change causes a deterioration in historical tracking performance. In other words, the OECD has intervened judgementally in the statistical forecasting process in a way likely to have resulted in more negative projections.

The OECD’s forecasts are hardly authoritative. Back in March, the organisation projected no change in US GDP in the second quarter. The latest estimate shows growth of 3.3% annualised.

The modest improvement in services sector activity reported in today’s purchasing managers’ survey for August is a welcome antidote to current excessive economic gloom. As suggested in a previous post, business and consumer surveys earlier in the summer were artificially depressed by the temporary surge in oil prices. Taking into account manufacturing and construction results released earlier in the week, the PMI surveys are consistent with a stagnant rather than contracting economy.

In an article discussing economic prospects and policy options, former MPC member Charles Goodhart has argued that the Debt Management Office should reduce gilt issuance in favour of increased sales of short-term Treasury bills. This is an excellent idea: it would help to arrest the recent worrying slump in broad money supply growth and is a more appropriate response to current conditions than a cut in official rates.

A government running a budget deficit injects money into the economy. If the deficit is financed by selling gilts to the non-bank private sector, the cash injection is reversed, leaving the money supply unchanged. However, sales of Treasury bills are less likely to have this sterilising effect, because they are bought mainly by banks rather than non-banks. So the combination of the budget deficit with Treasury bill financing boosts the money supply.

Annual growth in adjusted broad money M4 – excluding deposits of intermediate “other financial companies” – fell from 13.6% to 6.5% between June 2007 and June 2008. In the second quarter alone adjusted M4 rose by only 3% annualised. I think M4 growth of 6-8% per annum is consistent with achievement of the inflation target over the medium term. A lower rate of expansion would risk unnecessary economic weakness and an inflation undershoot.

Goodhart’s proposal offers a way of boosting monetary growth without cutting official interest rates – risky against a backdrop of high inflation expectations, sterling depreciation and fiscal deterioration. Suppose the DMO switched half of the financing of a £50 billion annual budget deficit from gilt sales to the non-bank private sector to Treasury bill sales to banks. Ceteris paribus, this would boost annual broad money growth by 1.4 percentage points.

As discussed previously, the authorities could also support monetary expansion and the housing market by slowing down the rate of contraction of Northern Rock’s balance sheet.

The Goodhart suggestion is the mirror-image of proposals made in 2006/2007 for the DMO to curb then-rampant monetary expansion by “overfunding” the budget deficit through additional gilt issuance. This would have helped to limit credit and housing market excesses.

The Treasury and Bank of England ignored such proposals at the time. As Goodhart notes, his latest policy suggestion would require more gumption on the part of the authorities than has been shown to date.

Last autumn I argued the consensus was too pessimistic about US economic prospects while neglecting the risk of serious weakness in Europe.

According to the latest vintage of data, US GDP rose by 2.2% in the year to the second quarter. This compares with increases of 1.5% in the Eurozone and 1.4% in the UK.

US pessimists have now rolled their forecasts of weakness into the second half of the year. GDP will slow sharply, they argue, as tax rebate stimulus reverses and slumping foreign growth hits exports. Real personal consumption in July was 0.4% below the second-quarter average.

I agree that the growth contribution of consumer spending and net exports will fall. However, the July real consumption number was depressed by a temporary spike in energy prices. Nominal spending actually grew by 0.2% on the month. Real consumption should revive in August and September.

Moreover, the stocks cycle and a diminishing drag from housing construction should compensate for smaller contributions from consumption and trade. The ratio of inventories to sales has fallen sharply, suggesting firms have been surprised by the resilience of final demand – see chart. Even a stabilisation of stock levels will give a sizeable lift to second-half GDP.

What could go wrong? A faster decline in employment could undermine my forecast of consumer resilience. August numbers released on Friday will be important but it would be surprising if firms stepped up job-shedding following solid second-quarter GDP expansion. Growth in withheld employment taxes – a coincident indicator of labour income – has strengthened in recent weeks, arguing against labour market deterioration.