The Resolution Trust Corporation (RTC) was set up in 1989 to manage and dispose of the assets of failed savings and loan (thrift) institutions. According to a General Accounting Office report, the RTC closed 747 institutions with $402 billion in book value of assets. By the time it was wound up in December 1995, the RTC’s remaining assets were down to $8 billion and it had incurred estimated direct losses of $88 billion.

The Treasury, Federal Reserve and Congressional leaders are reportedly discussing plans to create an RTC-type body to purchase so-called failed assets from US financial institutions. Such an approach has been endorsed by a former Fed chairman, a former Treasury secretary and a former US comptroller of the currency. The original RTC, however, assumed assets only after savings institutions had failed and been placed into conservatorship (the current status of Fannie Mae and Freddie Mac) or receivership. By contrast, the latest proposal is designed to prevent further financial failures.

The original RTC bailed out the depositors of failing institutions but not equity-holders or junior creditors. Market participants are betting that the new scheme will be different, contributing – together with the ban on new short sales – to today’s surge in financial shares. The benefit to equity-owners, however, will depend on the price at which any new RTC-type body purchases toxic assets. Who will establish the “correct” level, and how? Too high a price will enflame criticisms of a bail-out and bolster calls for tighter regulation. Too low a price risks leaving banks with insufficient capital to weather future financial storms.

The Fed has hugely increased its lending against lower-quality collateral since the credit crisis broke. It has, however, sterilised the impact of this lending on the volume of cash circulating in the banking system by selling Treasury securities. This was necessary to prevent the fed funds rate from falling beneath its policy target.

The change in the composition of the Fed’s assets has raised concerns about its financial strength. Its non-conventional lending will rise significantly further as a result of the $85 billion credit facility for AIG agreed this week. Sterilising this liquidity injection via further sales of Treasuries would reduce its holdings of such securities to undesirably low levels.

The US authorities therefore yesterday announced a new “supplementary financing programme”, under which the Treasury will sell additional Treasury bills and deposit the proceeds at the Fed. This has the effect of draining liquidity from the market without reducing the Fed’s own holdings of Treasuries further.

Should the Fed follow the example of the Bank of Japan in 2001 and stop sterilising its liquidity injections? The BoJ’s policy of “quantitative easing” flooded the banking system with reserves – see chart – and is argued by some to have been instrumental in Japan’s escape from deflation.

Under current arrangements whereby the Fed does not pay interest on bank reserves, unsterilised liquidity injections would push the Fed funds rate down to zero. The Fed could, however, avoid such an outcome by paying interest on bank balances at close to the fed funds target rate, currently 2%.

The main objection to such a suggestion is that, unlike Japan in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk undermining the dollar and reigniting commodity prices. The surge in the gold price over the last 24 hours is a taster of the possible implications.

Minutes of the September MPC meeting partially vindicate the recent dovish shift in my MPC-ometer. The vote changed from 1-7-1 in August (Besley seeking a 25 bp hike, Blanchflower a 25 bp cut) to 8-1 (Blanchflower voting for a 50 bp cut).

Taking into account the September vote and available data on the other inputs, the model suggests a knife-edge October decision. Further weakness in consumer and business surveys released in late September and early October – plausible in light of recent financial events – would tip the balance in favour of a cut.

Exchange rate developments will also be important. MPC members were concerned by the plunge in sterling during August but the effective index is currently 1.5% higher than at the time of the September meeting.

The MPC will wish to avoid the impression of cutting rates to rescue miscreant banks but current financial turmoil clearly has negative implications for credit supply and the wider economy.

Labour market figures also released today showed a shock 32,500 rise in claimant-count unemployment in August, boosting fears that the economy is already in recession. However, my research suggests that job vacancies are a better coincident indicator than unemployment. The 8% drop over the last three months is consistent with stagnant rather than contracting GDP – see chart.

The annual increase in UK consumer prices climbed further to 4.7% in August but retail price inflation slowed from 5.0% to 4.8%. The RPI measure will fall beneath CPI inflation over coming months. The gap between the two may exceed one percentage point by mid 2009 – the largest since 1993.

The chart shows my updated forecasts incorporating the latest numbers. Key assumptions include:

• Unprocessed food price inflation slows gradually from 13% in August to 2.5% by December 2009.
  

• Electricity / gas tariffs rise by a further 10% in September but energy prices are stable thereafter.
  

• “Core” CPI inflation – excluding unprocessed food and energy – slows gradually from recent rates, reflecting economic weakness and a fading impact from sterling’s depreciation.
  

• The housing depreciation component of the RPI, which tracks house prices, falls by 15% by mid 2009, stabilising thereafter. (The CPI excludes housing depreciation.)
  

• Bank rate is cut by half a point to 4.5% by the end of 2008, remaining stable in 2009.
  

On these assumptions, annual CPI inflation returns to the 2% target in September 2009. However, RPI inflation falls below 2% in June next year, reaching 1.1% in September. Of course, further Bank rate cuts during 2009 would imply still-lower RPI numbers.

While lower interest rates contribute, falling house prices are the key reason for the forecast RPI / CPI divergence. The housing depreciation component carries a 5.5% weight in the RPI so the assumed 15% annual decline in mid 2009 subtracts 0.8 percentage points from the annual RPI increase.

The coming plunge in RPI inflation will lower inflation expectations, subdue wage settlements and boost real income growth. It should also make it easier for the MPC to justify cutting Bank rate while CPI inflation is still above target. I expect the first move to occur as early as next month.

Last week the US authorities rescued Fannie Mae and Freddie Mac, judging them “too big to fail”. This week the authorities have refused to bail out Lehman, on the basis that the firm’s failure is unlikely to trigger a systemic crisis. These judgements are defensible.

The risk of Merrill Lynch being the next domino to fall has been removed by its purchase (at a premium) by Bank of America. With the Fed ready to supply unlimited liquidity against an expanded range of collateral, including equities, fears of financial Armageddon are overdone.

Credit conditions will remain tighter for longer, with negative implications for the economy. However, lower energy prices will provide some offset – global headline inflation is about to fall sharply, boosting real incomes and creating scope for central banks to cut interest rates.

Based on recent crude oil and natural gas prices, the annual change in the energy component of the US consumer price index may fall from +29% in July (August numbers are released tomorrow) to -10% in early 2009 – see chart. Assuming no change in non-energy inflation, this would push headline CPI inflation down from 5.6% in July to about 2% by early next year.

In the UK, CPI inflation is likely to peak at about 4.8% in September before embarking on a steady decline. With wage settlements stable, money growth weakening and the economy stagnant, the MPC should be able to cut interest rates either next month or by November at the latest.