Irish 10-year gilts are currently trading on a yield spread of 150 basis points (bp) over Bunds, down from a peak of 270 bp a year ago and compared with 300 bp for Greek bonds. This seems modest compensation for the financial risks. Irish and Greek spreads were similar as recently as November.

Ireland gained plaudits for a tough December Budget that cut the projected 2010 general government deficit from 13.5% of GDP to 11.6%. Following the further measures announced this week, however, Greek plans are more ambitious, targeting a budget shortfall of 8.7% of GDP this year.

Ireland’s stability programme envisages a decline in the deficit to 2.9% of GDP by 2014, a reduction of 8.7 percentage points over four years. This looks impressive but assumes €5.5 billion of unspecified future fiscal retrenchment. On current policies, the 2014 deficit would be 5.6% of GDP.  This compares with UK general government borrowing of 4.6% of GDP in 2014-15 projected in December’s Pre-Budget Report.

Within general government, the Exchequer or central government deficit is projected to decline by 26% in 2010. The shortfall in January and February, however, was 15% higher than a year before. Current spending fell by 5% but current receipts were down by 18%. Ireland is lagging the global recovery – the OECD’s leading index is up by 3% over the last 12 months compared with gains of 10% and 9% for its Eurozone and UK indices. With the UK accounting for more than a fifth of trade, recent sterling weakness against the euro is unwelcome.

Ireland’s banking system is critically dependent on ECB life support. Central Bank of Ireland lending to banks was €98 billion at the end of January, the equivalent of 60% of annual GDP. This represents 13% of total Eurosystem lending to banks compared with Ireland's 2% share of Eurozone GDP. The Bank of Greece's lending to banks amounts to 20% of Greek GDP while numbers for Spain and Portugal are much lower – see previous post.

A renewal of market worries about Ireland would be expected to be reflected in a withdrawal of funds from its banking system, necessitating increased ECB support. Irish central bank lending is down from a peak of €130 billion in June 2009 but rose in December and January. This bears monitoring: an increase in lending in mid 2008 preceded a sharp rise in the Irish / German yield spread – see chart.

The “MPC-ometer", discussed in numerous posts between 2007 and early 2009, is designed to predict monthly Monetary Policy Committee decisions based on incoming economic and financial data. The model suggests that policy tightening will soon be necessary, barring new “shocks”. This contrasts with the message of the February Inflation Report but news may force the MPC to execute a swift U-turn. An attempt to maintain inappropriately loose policy settings could accelerate sterling’s slide, further undermining the credibility of the Report's forecast of lower inflation.

The MPC-ometer is designed to predict the weighted-average interest rate vote of the Committee’s members. For example, if five want to raise official rates by 25 basis points (bp) while four prefer no change, the weighted-average vote is +14 bp (five-ninths of 25). If it is assumed that votes are either for no change or a move of 25 bp – reasonable under “normal” economic and financial conditions – then the model forecasts an actual rate change when the weighted-average prediction is greater than +12.5 or less than -12.5 bp. Introduced in September 2006, the MPC-ometer performed well over the subsequent two and a half years, correctly signalling the month and direction of 12 out of 13 rate movements – two more than the mean economists’ forecast from the monthly Reuters poll.

The MPC-ometer’s 12 inputs were selected on the basis of statistical analysis and can be grouped into indicators of economic activity, inflation and financial market conditions. The inflation sub-set is largest, comprising the latest headline annual increases in consumer prices and average earnings as well as several measures of expectations. Activity indicators include GDP growth and business / consumer confidence while credit spreads and movements in share prices and the exchange rate are used to gauge financial conditions.

A review of its forecasts during the period of unchanged rates since last March indicates that the MPC-ometer has continued to provide guidance about policy decisions. Specifically, it predicted further easing moves in May and August, months in which the MPC announced a £50 billion expansion of asset-buying plans. The model suggests that the MPC regards £50 billion of additional purchases as equivalent to a reduction in Bank rate of about 17 bp. On this basis, the £200 billion programme has substituted for a further rate cut of about 70 bp.

The weighted-average interest rate vote forecast by the model was negative between April and November last year, consistent with a residual easing bias. It rose, however, to +3 bp in December and +10 bp in January before falling back to +2 bp in February in response to preliminary figures showing GDP growth of only 0.1% in the fourth quarter. The forecast has rebounded to +12 bp in March, reflecting higher inflation, further gains in business and consumer confidence – both now well above long-run average levels – and upwardly-revised GDP expansion of 0.3% last quarter.

The MPC-ometer suggests, therefore, that as many as four members will vote to tighten policy this week. The February Inflation Report and more recent MPC communications indicate that such an outcome is highly unlikely. The current divergence between the model's forecast and MPC behaviour raises three possibilities.

First, the model may be signalling an imminent shift in the Committee's thinking. It has sometimes been "early" historically. Economic news and market developments since the Report was prepared have weakened the case for retaining an easing bias and may have emboldened members concerned about excessive policy laxity.

Secondly, the model may simply have broken down. Estimated on data since the MPC's inception in 1997, it may be failing to capture the full range of influences on monetary policy in the wake of a deep recession. This argument, however, is weakened by the similarity of the model's prediction and the latest vote of the Sunday Times Shadow MPC, which also has a good forecasting record. Three Shadow MPC members voted to raise Bank rate by half a percentage point this month – see David Smith's blog for the minutes.

This leads on to the third possibility, which is that the MPC's historical reaction function, rather than the MPC-ometer, has broken down. The Committee has, in effect, shifted to "inflation targeting lite", downplaying the requirement of its remit to achieve the 2% inflation target, defined by the consumer price index without exclusions, "at all times" in favour of supporting an economic recovery and promoting fiscal tightening by promising a monetary-policy "pay-off". Market suspicions of such a shift may be contributing to current sterling weakness.

GDP fell by 6.2% between the first quarter of 2008 and the third quarter of 2009 before recovering in the fourth quarter. The drop exceeds the peak-to-trough decline of 6.0% during the 1979-81 recession.

The recent GDP reduction, however, was magnified by a large fall in oil and gas production, reflecting reserves depletion. Oil output rose during the 1979-81 recession, when the North Sea was coming on stream.

With North Sea production driven by supply capacity rather than domestic or global demand, it may be more appropriate to focus on non-oil output when comparing economic weakness across cycles.

On this basis, the recent recession was less severe than 1979-81: the peak-to-trough fall in non-oil "gross value added" is currently estimated at 5.8% versus 6.4% – see chart.

Broad money trends remain weak: M4 excluding money holdings of non-bank financial intermediaries was unchanged in January and has contracted at a 1.9% annualised rate over the last six months. This weakness, however, is compatible with both a solid economic recovery and inflation overshooting the 2% target.

The key monetary driver of the business cycle is the corporate liquidity ratio – companies' money holdings divided by their bank borrowings. This ratio is a major influence on firms' decisions about capital spending and employment, with the latter driving household income and, in turn, demand. In contrast to aggregate broad money, corporate M4 rose by an annualised 4.6% in the six months to January.

The corporate liquidity ratio forewarned of the recession in 2007 at a time when aggregate money and credit were still rising strongly. It reached a low in early 2009 and has recovered significantly, suggesting an imminent pick-up in business spending and hiring. Excluding the struggling real estate sector, the ratio is above its average level since the late 1990s – see chart.

Firms have been able to rebuild their liquidity despite weak aggregate M4 growth because of a fall in the demand to hold money by households and institutional investors. This partly reflects a revival in confidence in markets; in addition, the negative real post-tax return on bank deposits may be triggering a major rebalancing of portfolios.

The current monetary environment resembles the aftermath of the 1974-75 recession. GDP rose by 6% in the first two years of the subsequent recovery despite a 6% contraction in the real broad money stock. The corporate liquidity ratio increased strongly before this upswing as household and institutional money demand fell in response to negative real interest rates. Inflation accelerated as the recovery developed.

The 1976 sterling crisis was caused partly by fiscal laxity – public sector net borrowing reached 7.0% of GDP in 1975-76 – but monetary policy was also too loose, with interest rates held below inflation and the deficit financed largely through the banking system. Current Bank of England policy is identical to that pursued by the monetary authorities in 1975-76 and carries a significant risk of similarly inflationary consequences.