Major British banks (i.e. the high-street groups covered by British Bankers' Association statistics) incurred impairment charges of £31 billion in the first half of 2009, up from £26 billion in the second half of 2008, according to recent interim statements. As explained below, a comparison with the bad debt cycles of the early 1980s and early 1990s suggests further provisions of £100-150 billion over the three and a half years to the end of 2012.

More optimistically, the same group of banks made pre-impairment operating profits of £26 billion during the first half. Providing this run-rate is maintained, cumulative profits between the second half of 2009 and 2012 should be sufficient both to cover future impairments and allow some addition to capital, implying no need for a further government "bail-out".

Loss provisions by major banks totalled 9% of credit exposure over the five years from 1982 to 1986, following the 1979-81 recession, and 7% over 1989-93, encompassing the 1990-91 recession. The 1982-86 figure includes losses on sovereign loans, although these were not formally recognised until later in the 1980s. (See previous post for more details.)

A similar loss rate, i.e. between 7% and 9% over five years, is plausible in the current cycle. It is not clear that recent bank behaviour was any more reckless than in the rush to lend to developing countries in the late 1970s or the property lending boom of the late 1980s. Moreover, nominal and real interest rates are much lower than in the 1980s and 1990s, which should limit defaults.

Based on 2008 exposure, a 7-9% rate of attrition would imply credit losses of £190-240 billion over the five years 2008-12. Impairment charges totalled £64 billion in 2008 and the first half of 2009 so this suggests losses of £125-175 billion over the three and a half years to the end of 2012.

In addition to impairment charges, however, Lloyds, HBOS and RBS recorded a combined net trading loss of £23 billion in the 18 months to mid 2009, reflecting writedowns of securities. On the basis that banks held a much greater proportion of credit exposure in securitised form in the current cycle, such writedowns should be included in total losses recognised to date when comparing with the early 1980s and early 1990s.

A conservative approach is to incorporate only the net trading loss of these three banks, rather than aggregate trading writedowns. (Writedowns by other banks have been offset by income from other trading activities.) Assuming no further trading losses, this reduces the forecast range for provisions to £100-150 billion between the second half of 2009 and 2012.

The chart translates this range into a half-yearly profile, assuming that impairments decline steadily from a peak in the first half of 2009. The middle of the range implies annual totals of £57 billion, £40 billion, £23 billion and £6 billion over 2009-12.

Banks' pre-impairment profits of £26 billion during the first half of 2009 incorporate £6 billion of trading gains by Barclays and RBS, offset by a further £3 billion loss by Lloyds / HBOS. Investment bank profits could be less favourable going forward but any decline should be offset by higher net interest income as average lending / deposit rate spreads recover from recent lows – see previous post on banks' margins.

If pre-impairment profits are stable at £26 billion per half-year – arguably cautious – and impairment charges total £100-150 billion between the second half of 2009 and 2012, banks will earn cumulative post-provision profits of £30-80 billion by the end of 2012. This surplus will be available to boost capital levels, on top of any addition from further fund-raising in markets.

The August Inflation Report is much less dovish than the market expected and signals that the Monetary Policy Committee now has a neutral policy bias, following the £50 billion expansion of QE announced last week.

The mean inflation forecast based on an unchanged level of Bank rate is an estimated 2.1% and rising at the two-year horizon. This is up from 1.7% in May and a record low 0.4% in February, and the first above-target projection since August last year. The deviation from 2% is an indicator of policy bias and has often signalled rate moves – see chart.

This inflation view rests on a respectable economic recovery but the MPC's GDP forecasts are not particularly aggressive. Output rises by about 2% in the year to the second quarter of 2010 in the central case based on unchanged rates. Risks, however, are weighted to the downside, so the mean projection is only about 1.5%.

In addition to the two-year-ahead projection, the MPC has raised its shorter-term inflation forecasts, partly reflecting a less optimistic assumption about domestic energy prices (expected to fall by 5% during the second half versus 15% in the May Report). After an undershoot in the second half, inflation returns to about 2% in early 2010.

Bank of England Governor Mervyn King referred to the likelihood of having to write a letter to the Chancellor explaining a fall in inflation to below 1% later this year. However, the central-case and mean projections for the third and fourth quarters are above 1%, suggesting that any move below will last a single month (and would not have occurred without the VAT cut).

Echoing earlier remarks in a speech, Deputy Governor Bean referred to the option of achieving a future tightening of policy initially by raising Bank rate, with gilt sales staggered over a longer period and conditioned on market developments. The difficulties of reversing QE imply that rate rises, when they begin, could be rapid.

Unemployment is still rising rapidly but job vacancies – a coincident rather than lagging indicator – suggest economic stabilisation. Vacancies bottomed in May and have edged higher in June and July. The rate of change over three months is still negative but has recovered to a level historically consistent with marginal GDP expansion – see chart.

The May trough in vacancies, like the peak in February 2008, was signalled in advance by the Market job placements index – see earlier post. The Markit index fell back in July but remains well above the low reached in December 2008.

Analysts are preparing to dissect the carefully-calibrated prose of tomorrow's Inflation Report for clues about the MPC's policy intentions. The effort is probably overdone, since the message of the Report will be summarised by a single number – the mean inflation forecast two years ahead assuming an unchanged level of Bank rate. If this remains below 2%, the implication is that the MPC retains an easing bias even after last week's QE expansion.

Ludicrously, the MPC refuses to publish its numerical forecasts until a week after the Inflation Report but the relevant figure can be gleaned from the charts, give or take a decimal point. It is important to focus on the mean forecast, rather than the central-case or modal projection, since this incorporates the MPC's weighting of upside and downside risks.

The mean two-year-ahead forecast based on unchanged rates reached a record low of 0.4% in February, signalling a strong easing bias. The following month the MPC reduced Bank rate by a further half point to 0.5% while announcing £75 billion of asset purchases, expanding this to £125 billion in May.

Partly reflecting these actions, the forecast was significantly higher in the May Inflation Report, at 1.7%. The shortfall from 2%, however, indicated that the MPC retained a modest easing bias.

It is possible that the MPC's inflation views have changed little since May, with the impact of weaker-than-expected GDP numbers and sterling appreciation counterbalanced by encouraging recovery signals from surveys and rising commodity prices. If so, last week's QE expansion should result in a further rise in the mean two-year-ahead forecast to close to 2%, signalling a neutral policy bias.

The consensus view, however, is that the surprise move reflected increased MPC concern about an inflation undershoot. If this interpretation is correct, the mean forecast based on unchanged rates will show little change from its May level of 1.7%, suggesting a continued easing bias. Of course, any fall in the forecast from 1.7%, despite expanded QE, would be a strong statement of increased MPC pessimism.

The MPC's shorter-term inflation projections will also be in focus tomorrow. Recent CPI numbers have been higher than forecast in May and the MPC's assumption that electricity and gas prices will be cut by a further 15% during the second half looks questionable. Food prices, however, are slowing sharply: July producer price numbers suggest another favourable impact in the CPI report to be released next week – see chart.

US labour market statistics for July suggest that the recession has ended, for two reasons. First, the (smaller) fall in payroll employment last month was offset by a rise in the length of the average working week. Aggregate hours worked in the private sector were therefore unchanged – the first month not to register a fall since last August. Since labour productivity has continued to rise during the recession, stability in hours worked implies an increase in output.

Secondly, the unemployment rate – derived from a survey of households rather than employer payrolls – fell slightly in July. Historically, a monthly decline following a sustained steep increase has marked the end of a recession – see chart. This is true even when the rate subsequently rises to a new peak, as it did in the aftermath of the 1990-91 and 2001 recessions.

Some commentators have dismissed the significance of the fall in the unemployment rate on the basis that it reflected a contraction of the labour force rather than a rise in the number of households in employment. This may be unwise. Historically, the first monthly decline after a significant peak has often been associated with a fall in the labour force, e.g. in 1975, 1980, 1982 and 2003. Moreover, a measure of payroll jobs derived from the household survey increased, by 70,000, last month.

The improvements in both the employer and household surveys are consistent with other labour market evidence, including a recent large decline in corporate layoffs (see here), falling initial unemployment claims, a stabilisation of help-wanted advertising and less negative employment readings in business surveys.