Central bank surveys of bank loan officers are a key gauge of the success of recent policy initiatives in easing credit conditions.

In the last US survey, conducted in January, the net percentage of banks reporting tighter credit standards on loans to firms remained close to its historic high. This indicator correlates closely with the yield spread of non-investment-grade corporate bonds over Treasuries – see first chart.

The April survey is due for release in early May. As the chart shows, however, the equivalent UK indicator from yesterday’s Bank of England credit conditions survey fell significantly between November / December and February / March. A similar drop in the US indicator would suggest better prospects for high-yield bonds.

The UK improvement may have been exaggerated by country-specific factors, such as government agreements with Lloyds Banking Group and the Royal Bank of Scotland to expand lending and the Bank of England’s purchases of corporate securities. Nevertheless, recent policy actions should contribute to at least some fall in the US indicator.

The net tightening percentage, inverted, is also a good leading indicator of the economy – see second chart – so a fall would boost recovery hopes.

The current global recession is shockingly severe. Does this imply an increased risk of “depression” or will an equally-dynamic recovery unfold later in 2009?

The first chart below updates a comparison of the current fall in industrial output in the Group of Seven (G7) economies with the three largest declines over the prior 50 years. Output is now about 18% below its peak in February 2008 – significantly greater than the biggest previous drop of 12% in 1974-75.

In the three prior cycles there was an inverse relationship between the size of the peak-to-trough output fall and the time taken to retrace it – the bigger the decline, the faster the recovery. It took 31 months for output to regain its peak level in the mid 1970s but 49 months in the early 2000s, when production fell by “only” 7%.

Commenting on an earlier post, a reader noted that the areas between the curves and the 100% horizontal line look similar. This area measures the cumulative percentage loss of output relative to its peak monthly level. This cumulative loss is shown in the second chart. The reader’s observation is correct. The loss was 186% over 1974-76, 181% over 1980-83 and 163% over 2000-04 – a remarkably narrow range.

So a bigger peak-to-trough decline may not imply that a recession is significantly worse in terms of cumulative output loss. There may be natural forces tending to equalise this cumulative loss across cycles. This observation, however, may apply only to “normal” recessions. Once the output fall exceeds a certain amount, the dynamics may change, resulting in a recession developing into a depression or slump.

The case for a V-shaped revival later in 2009 is that this tipping point has yet to be reached and unprecedented monetary and fiscal policy stimulus will strongly reinforce natural recovery tendencies. Optimistic indicators include a surge in inflation-adjusted narrow money growth – third chart – and a widening gap between sales and production – fourth chart – suggesting a potential big boost from the stocks cycle.

The cumulative loss approach outlined above can be used to generate a forecast path for G7 industrial output in an optimistic economic scenario. Specifically, assume that:

1. The cumulative output loss in the current recession / recovery cycle is 200% (i.e. slightly greater than over 1974-76).
2. February 2009 proves to be the trough.
3. Output subsequently recovers at a constant rate.

These assumptions define the forecast path shown in the fifth chart, which implies a return of output to its February 2008 peak by June 2010.

A key argument against a V-shaped rebound in output is that credit supply constraints will short-circuit natural recovery tendencies and render policy stimulus ineffective. Surveys of bank loan officers will be important for judging if credit conditions are easing, boosting economic prospects. The latest Bank of England survey, released today, was encouraging – final chart.

Services sector output data released today confirm that the economy continued to contract rapidly in early 2009. A monthly GDP estimate based on services and industrial output fell a further 0.6% in January, to stand 1.4% below its fourth-quarter average – see first chart. Monthly GDP has now declined by 4.2% from its peak last April.

The January result suggests GDP will fall by more in the first quarter than implied by the central projection in the Bank of England’s February Inflation Report – second chart.

The GDP decline should slow as the recent big drag from destocking abates. More promising monetary trends, if sustained, warrant hopes of a recovery in GDP from late 2009, though probably from a significantly lower level than implied by the Bank of England’s central projection.

The current recession could yet prove less severe than the catastrophic 1979-81 downturn. GDP would have to fall a further 2.4% from its estimated January level to match the quarterly peak-to-trough decline in the early 1980s.

UK monetary conditions were starting to improve even before the MPC embarked on “quantitative easing”, according to Bank of England data for February released today. Economic news is likely to remain grim for most of 2009 but the monetary foundations are being laid for a 2010 recovery.

Key features of today’s data include:

• Broad money M4, excluding holdings of financial corporations, grew by an annual 3.0% in February, up from 2.9% in January. This conceals a big rise, of 2.4% or 10.0% annualised, in the latest three months – see first chart.

• M4 holdings of non-financial corporations jumped by 5.3%, or 23.0% annualised, in the three months to February. Corporate money holdings are still down 2.1% from a year before but this compares with a 5.9% decline in November. The recovery is greater in real terms and suggests less pressure for retrenchment – second chart.

• Bank lending to non-financial corporations has also recovered, rising 1.6% in January / February combined. The larger rise in money holdings, however, has pushed the corporate liquidity ratio (money holdings divided by bank borrowing) up to its highest level since May 2008.

• Narrow money is weaker than broad money, with M1 – currency in circulation and overnight / sight deposits – up by just 0.3% in the year to February. The rise over the last three months, however, was 2.2% or 9.1% annualised.

• “Underfunding” has contributed to the recent pick-up in broad money – “sterling net lending to the public sector” accounted for 1.0 percentage points of the increase in M4 in January and February combined. This reflects purchases of gilts and Treasury bills by commercial banks, motivated partly by regulatory pressure to boost liquidity reserves. With QE kicking in, underfunding will rise further.