Recent US monetary trends have been mixed, with the broader M2 measure slowing sharply but M1 continuing to grow strongly. The economy should recover solidly during the second half but momentum could falter in early 2010 unless M2 revives.

M1 comprises currency and checkable deposits, while M2 adds small time deposits, savings accounts and retail money funds. M2 has risen at a 2% annualised rate over the last six months versus 12% for M1. The M2 slowdown is partly pay-back for a surge in growth in late 2008 and early this year – see first chart.

M2 was weak earlier last year, contracting in inflation-adjusted terms in the six months to August, just before the financial crisis snowballed. The impact on the economy was compounded by a fall in the velocity of circulation, as households and firms hoarded cash in response to rising perceived risks.

One sign that velocity might be declining was that narrow money M1 was even weaker than M2. M1 is a better measure of transactions money while M2 contains a large savings element and is likely to be boosted disproportionately by an increase in precautionary balances.

Fast-forwarding to the present, the recent M2 slowdown is less worrying because it follows a period of unusual strength and has been accompanied by continued rapid growth in M1, suggesting that velocity is recovering as financial markets normalise and economic uncertainty abates.

M2 weakness will warrant greater concern the longer it persists. Slower destocking and some revival in housing market activity may support credit and money trends later in the year. The Federal Reserve's securities purchase programme is scheduled to continue until the end of 2009, though its effects have recently been offset by other factors.

The mixed message from recent monetary data is echoed by the Fed's latest senior loan officer survey. The net percentage of banks tightening credit standards on commercial and industrial loans fell further between April and July but is still far above a level consistent with sustained economic expansion – second chart.

In December last year the Council of Mortgage Lenders (CML) predicted that the percentage of mortgages more than three months in arrears would rise from 1.8% at the end of 2008 to 4.4% by end-2009. First-half performance has been much better than expected, with the arrears proportion standing at 2.4% at the end of June.

As well as undershooting forecasts, current arrears experience compares favourably with the recession and housing market downturn of the early 1990s. The CML's series for three-month-plus arrears starts in 1995 but rough estimates for earlier years can be derived from data on six-month-plus cases. The current 2.4% arrears proportion compares with an estimated peak of about 6% in 1992 – see chart.

As pointed out on page 29 of the August Inflation Report, employment has fallen by less than at the comparable stage of the last downturn, partly reflecting cuts in real pay. Government schemes are also helping: 220,000 households were receiving income support mortgage interest payments in May (although such support was also available in the 1990s), while the Department of Communities and Local Government has estimated eventual take-up of the homeowners mortgage support scheme – which allows borrowers to defer interest payments for up to two years – at 42,000.

The key factor suppressing arrears, however, is a lower burden of interest service costs than in the early 1990s. Household interest payments peaked at 10.9% of disposable incomes in the fourth quarter of 2007 versus a high of 15.0% reached in the third quarter of 1990. One year into the 1990-91 recession, the interest burden was still 11.6% of income; the latest figure – for the first quarter of 2009 – is 8.7% and a further decline to 7-7.5% is likely, based on more recent Bank of England data on effective interest rates.

So the interest burden is now nearing the bottom of its historical range, despite a record level of debt. A bearish view is that mortgage defaults have simply been postponed because interest service will rise rapidly once official rates start to normalise. The impact of policy tightening, however, may be partly offset by a narrowing of current wide lending spreads. Moreover, MPC action will be conditional on a solid recovery, implying more favourable labour market conditions for borrowers.

(Please note: an earlier version of this post used a National Statistics series for household interest payments that nets off an estimate of consumption of financial intermediation services. The chart and text have been updated to include these payments in the analysis, as is appropriate. Thanks to an observant reader for spotting this omission.)

Professor Charles Goodhart has advocated charging banks for holding reserves at the Bank of England to encourage them to lend out the cash created by quantitative easing. He cites the example of Sweden, where the interest rate on the Riksbank's deposit facility has been set at minus 0.25%.

Current Swedish monetary policy and money market arrangements, however, are not comparable with the UK's. The Riksbank has cut its target interest rate, the repo rate, to 0.25% but has not engaged in quantitative easing, in the sense of asset purchases financed by creating new reserves. The deposit rate has fallen to -0.25% because it has recently been set 50 basis points below the repo rate.

Swedish banks make little use of the deposit facility because they are able to lend to the Riksbank in daily "fine-tuning" operations at the repo rate minus 10 basis points – i.e. 0.15% at present. The Riksbank's weekly statement shows that these fine-tuning loans currently stand at SEK176 billion versus deposits of only SEK39 million. So the negative deposit rate has little practical relevance.

In the UK, a key objective of market operations is to maintain overnight interest rates in line with Bank rate. If the Bank of England stopped paying interest on reserves, banks would attempt to earn a return on their cash by lending it out short term in secured money markets; this increased supply would push overnight rates close to zero. In other words, the change would undermine the anchor role of Bank rate and, by extension, the MPC's control over monetary conditions.

On the same logic, if the Bank charged banks for holding reserves, overnight rates would turn negative. Banks would then have an incentive to hold liquidity in the form of bank notes, which would at least maintain a fixed value, rather than deposits at the central bank or overnight loans. To prevent such behaviour, the Bank would have to place restrictions on banks' ability to convert their reserve holdings into bank notes – another fundamental feature of current monetary arrangements.

Paradoxically, banks as a group would be unable to avoid charges even if they increased their lending as desired, since the aggregate amount of reserves would be unaffected. While an individual bank might succeed in reducing its deposits, other institutions would find themselves holding more cash. The aggregate level of reserves is effectively fixed by the Bank of England, assuming a stable demand for bank notes.

Recent lending stagnation has been partly due to a fall in credit demand. To the extent that supply of loans is constrained, this reflects banks' efforts to conserve capital and reduce risk, rather than the competing attraction of earning 0.5% by holding cash at the Bank of England. Even if the technical obstacles could be overcome, a reserves-charging scheme would probably have little impact on lending behaviour.

As expected, food prices had a favourable impact on July consumer prices, cutting the annual increase by 0.14%. This effect, however, was offset by a pick-up in "core" inflation, resulting in the headline CPI rise remaining at 1.8%. This is well above the Inflation Report forecast of average inflation of about 1.25% in the third quarter and casts doubt on Bank of England Governor Mervyn King's suggestion of a fall below 1% later in 2009.

The CPI excluding food, energy, alcohol and tobacco rose by an annual 1.8% in July, up from 1.6% in June and the highest since November. Based on recent National Statistics research, this measure of core inflation would probably stand at 2.4-2.5% in the absence of December's VAT cut.

Stubborn core trends partly reflect the continuing impact of last year's sterling depreciation but also call into question consensus and Bank of England estimates of the sensitivity of inflation to rising economic slack. An alternative forecasting approach based on monetary growth may be more consistent with recent numbers than "output gapology" – see previous post.

Retail prices were down by an annual 1.4% in July but this compares with a 1.6% June decline. Interestingly, the housing depreciation component of the RPI – linked to house prices – rose last month for the first time since June last year. As argued in the previous post, RPI inflation should rebound strongly and exceed CPI inflation in 2010 as housing and interest rate effects unwind.

Energy price falls in late 2008 and early 2009 helped to offset the impact of a decline in labour incomes on consumer spending power. Energy prices have started to firm again recently but household budgets have enjoyed relief from a new source – a decline in food bills.

A surge in consumer food prices during 2008 squeezed real incomes and contributed to a cut-back in household spending. Food commodity prices, however, weakened sharply late last year and this decline has been feeding through at the retail level recently, with food components of consumer price indices in the US, Japan and Euroland recording an unusual fall over the last six months – see chart.

Food commodity prices recovered during the first half of 2009 but the Economist food price index is currently still 26% below the peak reached in July last year in dollar terms. Despite a headline-grabbing spike in sugar prices, the index has retreated 5% from a recent high in early June. So food CPI trends may remain subdued during the second half.

UK food inflation peaked at a higher level and has been slower to subside, reflecting sterling's big decline during 2008. With the pound recovering recently, however, this effect is reversing and food prices should suppress CPI numbers over coming months (producer prices suggest a favourable impact in the July report released tomorrow – see chart in previous post).