The shocking 1.5% GDP fall in the fourth quarter reflects a collapse in output in November and December. The chart shows quarterly GDP rebased to the peak in the second quarter of 2008 together with a monthly estimate derived from data on industrial and services production. Monthly GDP was little changed between September and October but plunged 1.7% in November and a further 0.7% in December. (The Office for National Statistics currently has little information on activity in December so the latter figure could be revised significantly.) The December reading was 1.0% below the fourth-quarter average, implying a large negative carry-over into the first quarter. Monthly GDP has fallen 3.6% from a peak reached in April last year.

Retail sales figures also released today show a 0.6% rise between the third and fourth quarters. With retail spending accounting for about 20% of GDP, this suggests that other components of demand – non-retail consumer spending, government consumption, investment, stockbuilding and net exports – subtracted 1.6 percentage points from economy-wide output in the fourth quarter. In other words, GDP excluding high-street spending fell about 2%.

The severe corporate liquidity squeeze is likely to have resulted in a major decline in business investment and stockbuilding. Housing investment and consumer spending on cars should also have made significant negative contributions while even government expenditure may have fallen – output of “government and other services” was down 0.5% from the third quarter. Trade figures for October and November suggest net exports of goods had little impact, despite sterling’s plunge.

As previously noted, monetary weakness in late 2008 implies continuing economic contraction during the first half but prospects for later in the year will depend on money and credit trends in early 2009. Fed-style operations to bypass the banking system and supply cash and credit directly to companies, financial institutions and households offer the best hope of avoiding a prolonged recession. The new Bank of England asset purchase facility is a promising first step – the MPC should push for rapid implementation and expansion of the programme.

UK labour demand is weakening rapidly, as evidenced by data released yesterday showing a 26% slump in the stock of job vacancies between March and December 2008.

The recent pace of decline is faster than during the recession of the early 1990s but less rapid than over 1974-76 and 1979-81 – see chart. In other words, while confirming a serious employment recession, vacancies have yet to indicate a downturn on the scale of the mid 1970s or early 1980s.

In the three prior recessions, the stock of vacancies reached a trough 18-24 months after peaking having fallen between 52% and 69%. This suggests a further decline of 35-58% from the December level, with a bottom between September 2009 and March 2010.

When the Bank of England buys securities from an insurance company or pension fund, the initial effect is to boost the institution’s deposit with its commercial bank, while the bank receives a credit in its reserves account at the Bank of England. The rise in institutional deposits constitutes an increase in the broad money supply M4, while the injection of reserves inflates the monetary base M0.

The Bank of England can “sterilise” the reserves impact of this transaction, for example by reducing its repo lending to the banking system or selling bills. However, providing any such operation is conducted with the banking system, there is no reversal of the initial rise in bank deposits and broad money M4.

For this reason, the Bank’s new asset purchase facility is likely to boost M4, even though additional Treasury bills will be sold to finance the scheme. M4 will rise providing 1) the Bank purchases securities from the non-bank private sector and 2) the additional bills are bought by the banking system.

In a speech last night, Bank of England Governor Mervyn King stated that “unconventional” monetary policy measures the MPC might use “would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies ... Provided the additional reserves are not simply hoarded by banks ... such asset purchases can increase the supply of broad money and credit”.

Mr. King is wrong. A positive impact on broad money does not depend on banks’ lending out additional reserves or even on the creation of new reserves. All that is required is that the Bank buys securities from non-banks and that any operation to sterilise the associated increase in reserves is conducted with banks.

This is not a technical point. A key reason for recommending quantitative action is to offset the drag on M4 from weak commercial bank lending. The attraction of the option is that it allows the authorities to influence directly the supply of money and credit, without relying on banks to transmit additional liquidity to the wider economy. Yet Mr. King appears to believe that any positive impact will occur only if “additional reserves are not simply hoarded by banks”.

As documented in a previous post, Mr. King’s speeches tend to be associated with a significant one-day decline in sterling. The effective index was 1.6% below last night’s close at midday.

CPI figures for December showed a much smaller decline than expected, probably reflecting sterling’s plunge during 2008 and an associated surge in manufactured import prices – up 14% in the year to November.

Annual CPI inflation fell to 3.1% from 4.1% in December but would have risen but for the VAT cut and lower energy costs. The Office for National Statistics estimates that the Pre-Budget Report tax changes would have subtracted 1.3 percentage points from the annual rate if passed on in full. It also reports that around two-thirds of prices collected in shops had been reduced, either at the shelf or the till, to reflect the lower VAT rate in December. This suggests that annual CPI inflation was depressed by 0.8-0.9 pp (two-thirds of 1.3).

A further negative impact, of 0.3 pp, came from lower energy prices. So annual CPI inflation would probably have risen from 4.1% to 4.2-4.3% without the VAT cut and a slump in world energy costs.

The VAT cut also accounts for the fall in annual “core” inflation – excluding energy, food, alcohol and tobacco – from 2.0% to 1.1%. The ONS estimate of the full CPI effect implies a reduction of 1.7 pp in the annual core rate in the event of full pass-through, or 1.1 pp with a two-thirds adjustment. This suggests annual core inflation would have risen from 2.0% to 2.2% – the highest since September – in the absence of the VAT cut.

The most important parts of today’s package of financial support measures are the new Bank of England asset purchase facility and the commitments by Northern Rock and RBS to expand lending relative to previous plans. These have the potential to have an immediate impact on credit supply and monetary growth.

The asset purchase facility is significantly smaller than equivalent Federal Reserve initiatives but can be expanded at the request of the Monetary Policy Committee. The Fed has bought $335 billion of commercial paper and plans to purchase up to $500 billion of mortgage-backed securities – the $835 billion total is the equivalent of 10% of the broad money supply M2. The Bank’s asset purchase facility has been set initially at £50 billion, equivalent to 2.6% of broad money M4 (a wider definition than US M2).

The monetary impact of this programme will be supplemented by a slowdown in the rate of contraction of Northern Rock’s mortgage book and the commitment by RBS to maintain credit availability to large corporations as well as homeowners and small businesses and increase lending by a further £6 billion over the next 12 months. Rock’s previous business plan implied a further £20-25 billion reduction in its mortgage lending in 2009. If its mortgage book is now stabilised, the Rock / RBS initiatives together could add £30 billion to credit supply in 2009 – equivalent to a further 1.6% of M4.

The initial £50 billion purchase under the Bank of England asset purchase scheme will be financed by issuing Treasury bills, implying no impact on the monetary base – so it does not amount to “quantitative easing”. However, growth in the base has already picked up as a result of the Bank’s expanded lending to the banking system and the priority now is to boost broad money M4. The scheme will achieve this providing 1) the Bank buys assets from UK companies and non-bank financial institutions and 2) new Treasury bills are bought mainly by banks, as is likely. In other words, if successful, the scheme will amount to “printing money” to buy private-sector assets. (In theory, the MPC could request that the monetary base impact of a future expansion of the programme is not sterilised by issuing more Treasury bills, implying “quantitative easing”.)

The other parts of today’s package – in particular, the asset protection scheme and the guarantee scheme for asset-backed securities – have the potential to boost credit supply and monetary growth over the medium term but only if fees are set at non-penal levels. Prior UK financial support measures have been more expensive than equivalent schemes in other countries, reducing their effectiveness.

While welcome, today’s package is not all that might have been desired. In particular, the authorities continue to resist pressure to “underfund” the budget deficit in order to boost M4. This could have an immediate and significant impact in relieving the current corporate liquidity squeeze and would complement efforts to improve credit availability.