Central banks are assuming the role of clearing houses for interbank business. Instead of bank A borrowing directly from bank B, A now accesses generous official credit facilities while B places its excess cash on deposit with the central bank. The new role should ease pressure on the banking system but may prove difficult to reverse.

The latest Fed balance sheet figures illustrate the change. Reflecting various new lending initiatives, total Fed credit rose by $503 billion, or 51%, in the fortnight to Wednesday. Meanwhile, banks with excess cash placed an additional $90 billion on deposit at the Fed and are likely to have taken up part of the recent increase in Treasury bill issuance, with the Treasury onlending the proceeds to the central bank.

The Fed’s increased willingness to extend credit amounts to an implicit guarantee on interbank liabilities. Any bank unable to refinance its wholesale borrowing can bridge the gap using official facilities. In theory, the Fed is protected by collateral requirements but these are now loose and the value of the security in any fire sale is highly uncertain.

The combination of the Fed’s expanded intermediation role with an increase in deposit insurance from $100,000 per account holder to $250,000 implies the US authorities now stand behind the bulk of the banking system’s liabilities. The Irish government has been criticised for introducing a blanket guarantee of its banks’ borrowings but the effect of recent US actions is similar.

Having resisted using its own balance sheet, the Bank of England is finally emulating Fed-style intervention. Its total assets rose by £69 billion, or 58%, in the fortnight to Wednesday. The Bank today announced a further loosening of its collateral requirements for its weekly auctions of three-month funds to include asset-backed securities based on consumer and corporate loans and asset-based commercial paper.

My ECB-ometer model suggests a 37% probability of a rate cut this week, up from 34% last month. See chart.

Assuming no change in the inputs, a reduction before year-end is now viewed as almost certain.

The further move towards easing territory reflects falls in business confidence, inflation expectations, M3 growth, short-term bond yields and stock markets. The main factor holding the model back from predicting a cut this week is the absence to date of any explicit dovish signal from ECB President Trichet.

The statement issued after tomorrow's meeting is likely to refer to diminishing upside inflation risks and / or increased downside growth risks, giving a clear hint of a move in November or December.

I shall post the MPC-ometer forecast on Monday but initial indications are consistent with my expectation of a rate cut at next week's meeting.

Detailed monetary statistics for August released by the Bank of England yesterday suggest a further deterioration in near-term economic prospects. In particular:

• M4 excluding money holdings of financial corporations rose by 5.4% in the year to August, the lowest annual growth rate since 2000 and barely higher than retail price inflation of 4.8%. The increase in the three months to August was just 3.3% annualised.
  

• Narrow money M1, comprising currency holdings and sight deposits, was 0.6% lower in August than a year before, the first annual decline since 1969.
  

• M4 held by private non-financial corporations (PNFCs) fell for the fifth month out of the last six and is now down 2.8% from a year ago. With bank lending to PNFCs continuing to rise, the corporate liquidity ratio – money holdings divided by borrowing – reached its lowest level since 1991.
  

• Public sector deposits with UK banks rose by £18 billion in August, offsetting a £16 billion decline in interbank deposits. There may be an innocent explanation but this suggests covert official support for one or more struggling banks.
  

M4, M1 and the corporate liquidity ratio are inputs to my recession probability model, designed to estimate the chances of an annual decline in GDP three quarters ahead. Also taking into account recent upward pressure on unsecured interbank interest rates and credit spreads, the model now suggests a 55% chance of an annual fall in GDP by the second quarter of 2009 – see first chart.

While above 50%, the probability estimate is still significantly lower than the 80% plus levels reached before the last three recessions. The model projects an annual GDP decline of 0.2% in the second quarter of next year, implying a stagnant or mildly contracting economy rather than a full-scale downturn – see second chart.

According to the model, the outlook is less negative than before prior recessions because of a smaller rise in interest rates and the large fall in the effective exchange rate over the last year, which will support net exports. The latter effect is already evident: trade contributed 0.5 percentage points to GDP growth between the fourth and second quarters.

Incidentally, revised GDP figures released today support my view that the economy had not entered a recession before recent financial eruptions. Excluding volatile oil and gas production, output edged 0.05% higher in the second quarter. Available evidence suggests activity remained broadly flat in July and August.

Federal Reserve Bank credit – the Fed’s aggregate lending to the banking system – rose by an unprecedented $219 billion, or 22%, in the week to last Wednesday. This reflected increases in currency swaps with other central banks, lending to banks to finance purchases of asset-backed commercial paper, primary dealer and other broker-dealer credit and the AIG loan.

The annual growth rate of Fed credit is now 32%, exceeding the levels reached at end-1999, when the Y2K computer scare led to a precautionary dash for cash, and after the 911 terrorist attacks, which temporarily disrupted the payments system – see first chart.

A key issue is whether the Fed will fully sterilise the impact of its increased lending on the monetary base (i.e. currency in circulation and bank reserves held with the Fed) – failure to do so would amount to “printing money”. As the chart shows, monetary base growth also rose sharply last week but this may reflect the technical difficulty of sterilising such a large injection immediately.

The short-term rise in bank reserves has pushed the actual level of the Fed funds rate well below the 2% target – see second chart. This amounts to an effective easing of policy, albeit possibly temporary.

While the jury is out, I doubt the Fed is yet ready to embark on an explicit policy of expanding the monetary base. Unlike Japan before its adoption of “quantitative easing” in 2001, the US still faces inflationary rather than deflationary risks. Flooding the banking system with reserves would risk a collapse in the dollar and a sharp rise in Treasury yields, exacerbating current financial difficulties.