The Bank of England’s central forecast, based on an unchanged 1% Bank rate, implies a further decline in GDP of about 1.9% from the fourth quarter of 2008 to a bottom in the third quarter of 2009. It then embarks on a strong recovery, rising by 3.2% in the year to the third quarter of 2010. Risks to this forecast, however, are judged to be “weighted heavily to the downside”. Indeed, the Bank’s mean projection – which takes into account this skew – entails a further 2.7% fall by the third quarter of 2009, with slower growth of 1.9% in the subsequent year.

The Bank’s forecasts can be cross-checked against the monetary leading indicator model described in earlier posts. This predicts GDP three quarters in advance based on current and lagged values of interest rates (three-month LIBOR), real money supply growth (both narrow and broad measures), the corporate liquidity ratio (companies’ bank deposits divided by their bank borrowing), the yield spread between corporate bonds and gilts, the effective exchange rate and share prices. The model’s forecasts can be expressed either as a probability of the economy being in recession (defined as an annual fall in GDP) or a numerical growth prediction.

The model supports the Bank’s forecast that recessionary forces will abate in late 2009. Based on available first-quarter data, the recession probability estimate falls significantly between the third and fourth quarters of 2009 – see chart – while the numerical projections imply a small GDP rise in the final quarter. However, the model casts doubt on the Bank’s forecast of a subsequent solid recovery. On the assumption that the input variables remain at their current values over the remainder of 2009, GDP is projected to grow by only 1.2% in the year to the third quarter of 2010 – well below the Bank’s central and mean forecasts of 3.2% and 1.9% respectively.

With the scope for further interest rate stimulus exhausted, a revival in monetary growth represents the best hope of achieving an outcome more in line with the Bank’s projections. The model can be used to assess the possible impact of the MPC’s new initiative to boost the money supply by buying gilts and other securities, financing purchases by creating new bank reserves. Suppose the programme results in a five percentage point rise in the annual growth rates of both broad and narrow money by the end of the third quarter of 2009. With all other input variables unchanged, the model forecasts GDP growth in the subsequent year of 2.2% – 1.0 percentage points higher than in the “base case”. This understates the impact because the monetary acceleration would be likely to affect other model inputs favourably: the corporate liquidity ratio would probably rise, while credit spreads might narrow and share prices rally as investors with higher cash balances deployed funds.

How big would Bank asset purchases have to be to have a monetary impact of five percentage points? Excluding deposits of “intermediate other financial corporations”, the broad money supply M4 stood at £1.7 trillion at the end of December so a 5% boost implies an increase of £85 billion. The Bank’s buying, however, will have a direct impact on M4 only if securities are purchased from domestic non-bank investors – essentially, insurance companies and pension funds, non-financial companies and households. Purchases from banks will increase M4 only if their lending rises as a result – far from guaranteed given current capital constraints and risk aversion. Assuming that one-third of the securities bought by the Bank is acquired from banks or overseas investors, the programme might need to amount to at least £125 billion to have the desired monetary impact.

The upcoming MPC meeting is intriguing. Despite an Inflation Report forecast showing annual CPI inflation far below target in the medium term if Bank rate remains at 1%, only David Blanchflower voted for a reduction of more than 0.5 percentage points in February. This suggests other MPC members believe that cutting Bank rate below 1% would have a negligible or even negative impact on the economy. The Report explains that, in the event of a further cut, banks might fail to pass on the reduction; alternatively, their interest margins would be squeezed, damaging earnings and lending capacity. If most MPC members held this view in February, as the vote suggests, it would seem logically inconsistent for those individuals to support a cut at this month’s meeting.

Some commentators have suggested that an unchanged 1% Bank rate would conflict with the MPC’s plans to finance asset purchases by creating new bank reserves. They argue that an expansion of reserves will push very short-term interest rates towards zero, undermining the main objective of the Bank of England’s money market operations – “to implement monetary policy by maintaining overnight market interest rates in line with Bank rate”. This appears to be incorrect. Under current arrangements, banks choose the level of reserves they wish to hold on average each month and are remunerated at Bank rate on balances close to these targets. In theory, the Bank could coordinate with banks to raise targets progressively so that reserves created by asset purchases continue to earn interest at Bank rate. In addition, the Bank could limit any decline in market rates by allowing banks to make greater use of its operational standing deposit facility, which pays Bank rate minus 25 basis points; this level would then act as a floor for overnight rates. The facility is intended to accommodate unexpected “frictional” payments shocks rather than a structural excess of reserves but the scale of its usage recently suggests that the Bank has adopted a liberal interpretation of this requirement. (Deposits averaged £5 billion during the December maintenance period versus reserve balances of £45 billion.)

Revised figures show that GDP fell by 0.02% between the first and second quarters of 2008, having previously been estimated to have risen marginally. So the recession began in the second not third quarter of last year.

A monthly GDP estimate can be calculated using output data for industry and services, which together account for 93% of total activity. This peaked in April, implying that the recession began in May last year – see chart.

After a 1.6% plunge in November, monthly GDP fell by a further 0.4% in December, to a level 0.8% below the fourth-quarter average. In other words, GDP would decline by 0.8% in the first quarter even in the unlikely event of activity stabilising in early 2009. For comparison, the Bank of England’s central forecast implies a 1.1% first-quarter drop.

The expenditure breakdown is not particularly reliable at this stage but suggests that inventory liquidation accounted for much of the 1.5% fall in GDP in the fourth quarter. Domestic final demand contracted by a smaller-than-feared 0.5%, with a large – but presumably temporary – rise in government spending providing support.

The GDP price measures are also subject to significant revision but do not support deflation claims. The deflator for gross value added at basic prices – which corrects for the depressing effect of the VAT cut – rose by 1.2% on the quarter for a 3.6% annual gain. (See here for more on inflation.)

On the face of it, Northern Rock is suffering significantly higher delinquencies on its mortgage lending than the industry average. According to yesterday’s 2008 results preview, residential loans more than three months in arrears were 2.92% of the total number of loans at the end of December, which compares with an industry figure of 1.87% (reported by the Council of Mortgage Lenders last week).

The Northern Rock number, however, has been inflated by its policy of encouraging borrowers to refinance their loans with other lenders. The number of mortgages in the Granite pool fell by 30% during 2008, a figure likely to be representative of the bank as a whole. With other banks tightening lending criteria, only Rock’s more credit-worthy customers will have been able to refinance elsewhere and it is reasonable to assume that most of these borrowers have continued to service their loans.

Accordingly, when comparing Rock’s arrears performance with the industry average, it may be more appropriate to express the number of cases as a proportion of the total including those who have moved to other lenders, i.e. the number at the end of 2007 rather than 2008. Adjusting for a 30% fall, this reduces the three months plus arrears proportion at the end of December to 2.05% – only slightly higher than the industry figure.

One way of moving borrowers off arrears is to repossess their homes. Properties accounting for 0.66% of the loans in the Granite pool at the end of 2007 were repossessed during 2008, which compares with an industry repossession rate of 0.34% last year. Northern Rock has therefore contained the rise in its arrears proportion by a relatively aggressive repossessions policy but the effect has not been large.

Arrears nationally are likely to continue to rise rapidly during 2008 – see here – and it is possible that Northern Rock’s relative performance will deteriorate more significantly in the process. Its rapid expansion during the late stages of the boom and an above-average loan-to-value ratio are reasons for pessimism but Rock avoided subprime lending and – unlike Bradford & Bingley – has limited exposure to the buy-to-let sector, where arrears are rising more rapidly.

Earlier posts on Northern Rock can be found here and here.

House price falls have pushed the national rental yield up to its long-run average, suggesting housing is now fairly valued by historical standards. However, if the yield were to overshoot the average by the same extent as it undershot during the boom – a not unreasonable assumption – house prices would fall by a further 16% from current levels.

The national rental yield is derived from national accounts data by dividing the sum of actual rents paid by households and imputed rents of owner-occupiers by the value of the housing stock. It averaged 3.59% between 1965 and 2007. The national yield is lower than alternative measures because it includes subsidised social housing, takes account of vacant properties and is calculated using end-period prices.

The most recent official figures are for 2007, when the yield stood at 2.84%. House prices fell by 18% in the year to December 2008, according to the Halifax index. Applying this decline to the value of the housing stock at end-2007, and taking into account rental growth of 5% in 2008, the rental yield is estimated to have risen to 3.63% by the end of last year – see first chart.

The end-2007 yield was 0.75 percentage points below the long-run average. If the yield were to overshoot by the same amount during the current downturn, rising to 4.34%, house prices would fall by a further 16% from their December 2008 level, assuming constant rents. The implied decline would obviously be larger to the extent that rents fall, as suggested by the last Royal Institute of Chartered Surveyors residential lettings survey – second chart.

A further fall of 16% would imply a peak-to-trough decline in inflation-adjusted house prices similar to the early 1990s housing downturn – see here.