The commentariat is in uniform agreement that large-scale EFSF leveraging and bank recapitalisation are needed to stem the Eurozone crisis. Could the opposite be true?

The view here is that the ECB has been a key driver of Eurozone woes by allowing the real money supply to contract from late 2010, compounding its error by raising interest rates this spring. Resulting economic weakness has undermined fiscal consolidation plans and, by extension, market perceptions of sovereign solvency.

Even a leveraged EFSF would be unable to offset the damage inflicted by continued deflationary monetary policy. A refusal to expand the facility could be the best way of forcing the ECB to change course. Market turmoil following such a decision could hand Sig. Draghi the bargaining power to overrule the Bundesbankers and cut interest rates while launching “proper” QE – a direct liquidity injection via large-scale bond purchases spread across sovereign markets in proportion to national GDPs (thereby avoiding the charge of a backdoor bail-out of peripheral miscreants).

Moving the goal posts yet again to require banks to raise capital ratios significantly over a short period, meanwhile, would lead to a renewed monetary squeeze, as demonstrated by the disastrous economic fall-out from the forced UK injections in late 2008.

Investors, perhaps, should hope for a “disappointing” outcome from the forthcoming summits, with any knee-jerk sell-off in markets providing a buying opportunity as the ECB is forced to launch rescue action. Conversely, initial euphoria in the event of a big headline package could fade rapidly if the price of “victory” is that Bundesbank deflationists remain at the monetary controls.

The forecasting approach employed here emphasises monetary analysis while seeking confirmation from leading indicators – see a post last week for the latest application.

An alternative approach with a good record – and equally shunned by the consensus – is based on economic cycles.

The three most important cycles are the 3-4 year Kitchin inventory cycle, the 7-11 year Juglar business investment cycle and the 15-25 year Kuznets cycle in housing construction / prices and associated consumer spending.

Big recessions occur when downturns in the three cycles coincide. In 2008-09, the shift of US housing from long boom to bust triggered a financial crisis and credit crunch that forced companies simultaneously to slash investment and stocks.

The view here is that the last such synchronised downturn occurred in 1974-75 when US housing construction slumped on a similar scale to recently while a surge in inflation ravaged corporate finances and liquidity, tipping the Juglar and Kitchin cycles into scheduled downswings.

Partly for this reason, previous posts have used the pattern of the global recession and recovery in the 1970s to forecast the current cycle – see, for example, here.

The chart below provides an update, comparing the six-month change in G7 plus emerging “E7” industrial output in the current cycle with that of G7 production in the 1970s. (G7 output was an adequate proxy for the world economy in the 1970s, when the E7 were small and / or isolated from the capitalistic system.)

The similarity between the two cycles remains remarkable, with the recent global economic slowdown echoing similar weakness in 1977-78 (October 2011 = December 1977). The interpretation here is that these slowdowns reflect the first post-slump downswing in the 3-4 year Kitchin inventory cycle. In the 1970s, the Juglar and Kuznets cycles were in the early stages of upswings so the Kitchin cycle downswing was insufficient to trigger another recession.

If this interpretation is correct and the current cycle continues to follow the 1970s pattern, global economic momentum should bottom around the end of 2011 and pick up during 2012 – a scenario also suggested by monetary trends but yet to be confirmed by leading indicators, as last week’s post discussed.

Put differently, with the Kuznets and Juglar cycles in bottoming or early upswing phases, a further large negative shock to the global economy is probably required to tip the recent loss of momentum over into a full-scale recession.

Claims that banks have taken advantage of the low level of Bank rate to widen interest margins and boost profits continue to be contradicted by Bank of England data on deposit and lending rates.

The chart shows estimates of the weighted-average interest rates paid on sterling deposits and charged on sterling loans vis-à-vis the UK non-bank private sector (i.e. M4 deposits and lending). The average deposit rate has been rising gradually since early 2010, probably reflecting banks competing to attract inflows to replace maturing funding, such as borrowing enabled by the special liquidity scheme.

The average lending rate, by contrast, fell during 2010 and has stabilised in recent months despite the rising cost of deposit funds. The lending / deposit rate spread, therefore, has fallen to a new low in data extending back to 1998. Bank bashers please note.

A cut in Bank rate from 0.5% to 0.25%, as recently suggested by the Ernst & Young Item Club, could intensify the squeeze, with funding pressures making it difficult for banks to lower deposit costs sufficiently to compensate for the reduced yield on tracker mortgages and other loans linked to official rates.

The UK consumer prices index in September was 6.5% above the level implied if the MPC had achieved an average 2% inflation rate since the target was switched to the CPI in December 2003.

The previous target was for 2.5% RPIX inflation (i.e. retail prices excluding mortgage interest). The September level of RPIX was 7.8% above the level implied by an average 2.5% inflation rate since December 2003.

The MPC’s claim that this overshoot was unavoidable and outside its control is wrong. Monetary policy determines the inflation rate over such a long period.

The MPC’s claim is undermined by the superior inflation performance of other countries similarly exposed to rising international input costs. Eurozone consumer prices, for example, are only 0.8% higher than the level implied by a 2% annual rate of increase since December 2003 (i.e. Eurozone inflation has averaged 2.1% since 2003 versus 2.8% in the UK).

The rise in CPI inflation from 4.5% in August to 5.2% in September was larger than expected here and by the market. The overshoot resulted from a combination of an even bigger impact from energy utility price hikes than allowed for along with a 0.2 percentage point rise in “core” inflation (i.e. excluding energy, food, alcohol and tobacco), from 3.1% to 3.3%. About half of the rise in the core rate is attributable to air fares, which are volatile from month to month.

The alternative RPI measure was slightly less grim, with annual inflation rising by 0.4 rather than 0.7 percentage points on the month to 5.6% – only just above a temporary 5.5% peak reached in February 2011. Those wishing to find a glimmer of hope in the report can cite a lower annual increase in the tax and price index, which also takes into account income tax and national insurance, than in February – 5.3% versus 6.0%.

While today’s upside surprise warrants some forecasting humility, it seems unlikely that CPI inflation will go any higher in October – an energy price hike by Npower (to be followed by EDF Energy in November) should be offset by a favourable motor fuel price base effect while air fare inflation may moderate. A sustained fall should then begin reflecting the VAT unwind, a slowdown in food and energy inflation following recent commodity price stabilisation and some moderation in “core” inflation in lagged response to economic weakness (as suggested by business survey pricing plans – see chart). The expectation here, however, remains that CPI inflation will trough well above the 2% target and may be trending higher again by late 2012.

Fundamentally, inflation reflects monetary conditions with a one- to two-year lag. This year’s awful inflationary experience confirms that monetary loosening was taken too far in 2009, with the MPC failing to correct the error last year. Sir Mervyn King now argues that monetary conditions are restrictive, as demonstrated by an annual contraction in the “old” M4 broad money aggregate, implying a medium-term risk of inflation undershooting the target. However, a broad liquidity measure constructed by Henderson including foreign currency deposits and public sector money-like instruments rose by 4.5% in the year to August – the fastest annual growth since mid 2008. There is a risk that liquidity trends will deteriorate if the Eurozone financial crisis intensifies but the MPC has jumped the gun by launching QE2 now. The hoses, in effect, have been turned on before the fire has started – although Sir Mervyn is doing his best to talk up the coming conflagration.

The strong rebound in equities this month reflects plentiful liquidity and an absence of bad news. The Dow Industrials, however, closed last week 7% above the “six-bear average” – the largest positive deviation since July. With major data and event risk through early November, a pull-back would be no surprise.

A post on Friday suggested that China needs to ease monetary policy soon to avoid a bumpy economic landing. India provides a lesson in overkill – real M1 was allowed to contract significantly and industrial output has subsequently slumped.

The hope here, based on recent monetary trends, is that US economic resilience will outweigh Eurozone weakness, sustaining global expansion. Solid September retail sales fit the scenario and hint at a recovery in the key ISM manufacturing new orders measure.

The best measure of investor sentiment remains in “panic” territory despite the recent rally. Add in “excess” liquidity and a possible turn in the global economic cycle and it is easy to paint a bullish scenario – if the negative dynamics in the Eurozone can be arrested.