First-quarter flow of funds accounts released yesterday by the Federal Reserve show a further decline in non-financial companies' borrowing requirement, defined here as their "financing gap" – capital spending minus domestic retained earnings – plus share purchases net of issuance. The borrowing requirement is a leading indicator of credit spreads – see chart and previous post.

The borrowing requirement amounted to 1.5% of GDP in the first quarter, down from a high of 9.5% in the fourth quarter of 2007. In the late 1980s and early 2000s, borrowing peaked eight quarters before the high-yield spread over Treasuries. Credit has rallied much earlier in this cycle, possibly because spreads reached more extreme levels in late 2008 than in the prior two bear markets. The historical two-year lead suggests that further significant spread compression could be delayed until 2010.

At 1.5% of GDP, the first-quarter borrowing requirement was below its average of 2.3% since 1985. The further fall last quarter mainly reflected a large cut in capital spending as companies slashed fixed investment and ran down stocks. A decline in net share buying also contributed, while firms offset profits weakness by reducing dividends, resulting in stable retained earnings.

Looking forward, an end to destocking should contribute to a significant rebound in capital spending over the remainder of 2009. The impact on the borrowing requirement, however, may be offset by a recovery in profits as economic growth resumes and a further fall in net share purchases, with companies using the opportunity provided by better markets to step up issuance.

The Bank of England's Bankstats publication this month contains for the first time a table providing detailed figures for "adjusted" M4 and M4 lending – i.e. excluding banks' business with financial intermediaries ("intermediate other financial corporations"). If these series had been made available 12-18 months ago, economists and the MPC would have been better able to anticipate the recession.

The Bank was aware of possible problems with its M4 and M4 lending measures in 2007: an article in the September Quarterly Bulletin proposed a redefinition to exclude intermediaries while the November Inflation Report warned that growth rates were being inflated by the financial crisis. Since May 2008, the Inflation Report has contained a chart showing the annual growth rate of adjusted M4; this was extended to M4 lending in August last year. The fuller data set published in the new Bankstats table could, in theory, have been made available at least a year ago.

The chart shows a measure of economic momentum based on the purchasing managers' surveys – a weighted average of the services new business and manufacturing new orders indices – together with the six-month growth rate (not annualised) of real adjusted M4 (i.e. deflated by consumer prices). In contrast to the headline measure, real adjusted M4 slowed abruptly in late 2007 following Northern Rock's implosion and contracted during the first half of 2008 as inflation spiked higher. This weakness warned of serious economic deterioration at least three months before the purchasing managers' indicator fell below the key 50 level in May 2008.

The MPC reduced Bank rate in December 2007, February 2008 and again in April then held it at 5.0% until October. It is debatable whether members pay much attention to monetary trends but, had the adjusted data been available, there is at least a chance that the Committee would have cut further over the summer despite a surge in headline CPI inflation to a September peak of 5.2%. It might also have been swifter to heed external recommendations for quantitative easing.

Just as it led on the way down, the adjusted money measure also foreshadowed the recent improvement in economic news. The six-month rate of change troughed last September and has recovered steadily, currently running at about 3% – a level historically consistent with economic expansion. The purchasing managers' indicator bottomed in November last year and the recent move back above 50 appears to confirm that the economy has stopped contracting.

Critics of the banks accuse them of boosting margins by failing to pass on Bank rate cuts to borrowers. The banks' last trading statements, however, complain of downward pressure on net interest income. Who is right?

The chart below shows estimates of average interest rates charged on M4 lending and paid on M4 deposits, derived from disaggregated Bank of England data. (The M4 data cover banks' and building societies' sterling business with UK households and corporations.) The difference between the average lending and deposit rates is a measure of banks' net interest margin.

The critics are factually correct to complain of a measly decline in lending rates. Between November 2007 and April 2009 Bank rate was cut by 525 basis points but the average interest rate on M4 lending fell by only 310 basis points. This implies much lower pass-through than during the last big easing of monetary policy, in 2001-03, when Bank rate fell by 250 basis points and the M4 lending rate by 220 basis points.

The benefit to banks of a higher margin on lending, however, has been entirely offset by the disappearance of their deposit margin. In November 2007, the average interest rate on M4 deposits stood at 4.6%, 115 basis points below Bank rate of 5.75%. By April 2009, it was 110 basis points higher – 1.6% versus 0.5%.

In other words, the M4 deposit rate fell by only 300 basis points between November 2007 and April 2009 – slightly less than the average lending rate. Far from bolstering their profits at the expense of hard-pressed borrowers, banks have actually suffered a further decline in their net interest margin over this period – see chart.

Why has the average deposit rate proved so sticky? Clearly the maximum possible fall would have been 460 basis points – its level in November 2007. In practice, banks have been forced to continue to offer interest on sight (i.e. instant access) deposits in order to retain funds – not least because of competition from state-run savings. Meanwhile, the unforeseen collapse in Bank rate has left them temporarily saddled with high term funding costs: the average interest rate on household bank time deposits was still 4.6% in April 2009.

As term funding matures and is refinanced at lower rates, banks should be able to reduce the M4 deposit rate towards Bank rate. Coupled with higher margins on new lending, this should allow a significant recovery in the lending / deposit rate spread. As the chart shows, the spread is currently at an historical low – even a 100 basis point rise would simply return it to the average over 1999-2005, before the recent credit bubble.

Banks are already being accused of profiteering despite a further squeeze in their net interest margin; imagine the furore if they succeed in boosting their profitability. Such a development, however, is needed to speed capital rebuilding and support future lending growth. Moreover, restoration of the margin to a normal level is the mirror-image of an appropriate repricing of credit risk – spread compression in 2006-07 contributed to the lending bubble.

Is the US labour market improving, or at least deteriorating less rapidly? Employees on non-farm payrolls dropped by 345,000 in May – lower than expected and down from an average of 612,000 over the prior three months. An alternative payrolls measure derived from the household survey, however, fell by 833,000, contributing to a further rise in the unemployment rate to 9.4%, a 26-year high.

The jury is out but two other indicators support the more hopeful message from the "official" payrolls series. First, a smoothed measure of employment taxes withheld at source (equivalent to UK PAYE) has edged higher since February – see first chart. Unsurprisingly, withheld taxes are a good coincident indicator of labour incomes and successfully delineated the last recession. (The numbers have been adjusted to take account of a cut in the withheld tax rate from April.)

Secondly, the outplacement firm Challenger, Gray & Christmas Inc's monthly tally of job-cut announcements has fallen steadily from a peak of 234,000 (seasonally adjusted) in January, reaching 111,000 in May – the lowest since September. The series correlates with weekly initial unemployment claims and suggests that claims will extend their recent small decline – second chart. This, in turn, would be consistent with an imminent peak in the unemployment rate.