The Eurosystem’s lending to euro area banks related to monetary policy operations (i.e. via repos and the “marginal lending facility”) has risen from €408 billion in April to €589 billion as of last week but remains well below a June 2010 peak of €870 billion. This lending, however, has been supplemented by an expansion of other forms of support – “emergency liquidity assistance” operations, other lending to banks and sovereign bond purchases under the securities markets programme (SMP). Total support is now back at the previous high and should continue to expand over coming weeks.

The following changes to the Eurosystem’s balance sheet have occurred since June 2010:

• Lending related to monetary policy operations has fallen by €281 billion.

• Ireland and Greece (at least) have instituted “emergency liquidity assistance” programmes, under which local banks borrow against inferior collateral at a penal rate. These programmes have been recorded under “other assets” on the respective central bank balance sheets. Eurosystem-wide “other assets” have expanded by €93 billion since June 2010.

• “Other claims on euro area credit institutions denominated in euro” have risen by €47 billion. The form and purpose of this lending is not disclosed but it could reflect “covert” support – an increase on the recent scale last occurred in September 2008 following Lehman’s collapse.

• The ECB has expanded its SMP sovereign bond holdings by €132 billion, with securities probably mostly purchased from banks. It has also recently embarked on a second covered bond purchase programme (CBPP2), intended to reach €40 billion by October 2012.

Aggregating the above categories gives a proxy for total support – this has risen from €886 billion in April to €1265 billion as of last week, close to a €1275 billion June 2010 record. A further significant expansion is likely, reflecting ongoing sovereign and covered bond purchases and likely strong demand for funds at the 13-month repo operation scheduled for 21 December.

The average 7-10 year Eurozone government bond yield – derived from country yields using debt weights – has risen by 90 basis points since early October, returning to the post-2008 peak reached in July. (The average yield is calculated by Thomson Reuters Datastream from data on 12 markets including the three bail-out countries.)

The increase reflects contagion into the core together with stability in German yields, a fall in which had previously provided an offset to rises elsewhere – capital fleeing other markets may now be leaving the euro area rather than seeking a “safe haven” in Bunds.

The yield rise threatens an inappropriate tightening of monetary conditions and warrants offsetting ECB action in the form of further rate cuts and an expansion of bond buying, though spread across national markets in proportion to GDP rather than focused on Italy and Spain. Such a country-neutral strategy would insulate the ECB from German criticism of launching a backdoor fiscal bail-out for peripheral miscreants.

The November Inflation Report is super-dovish and signals early further policy easing, confirming the message of the “MPC-ometer” model, which suggested that the MPC would either cut Bank Rate or boost the QE2 programme at its November meeting.

A key summary measure of the Committee’s bias is the two-year-ahead mean forecast for CPI inflation based on unchanged policy. This was 2.08% in the August Inflation Report but has been slashed to an estimated 1.25% this quarter – the lowest since the depths of the financial crisis in February 2009. (The projection, moreover, contains an upward bias because it excludes “the most extreme outcomes in the euro area”.)

The implied policy adjustment necessary to move the two-year-ahead forecast back to the 2% target can be estimated from “ready reckoner” sensitivities provided in an article assessing QE1 published in the last Bank of England Quarterly Bulletin. According to the article, “a 100 basis point cut in Bank Rate increases CPI inflation by about ½ percentage point after 18 to 24 months” while the effect of the £200 billion QE1 programme “was equivalent to a 150 to 300 basis point cut in Bank Rate”. These numbers imply that the ¾ point boost to inflation necessary to hit the 2% target in two years’ time would require either an impossible 150 basis point cut in Bank Rate or between £100 billion and £200 billion of additional gilt purchases.

At a minimum, therefore, the Inflation Report suggests that the MPC will either expand QE2 by £100 billion, or else combine a £75 billion increase with a quarter-point cut in Bank Rate to 0.25%. Further action is likely to be announced at the December meeting, barring surprise positive developments in the Eurozone.

Behind the gloomy headlines, today’s update of the OECD’s leading indicator indices suggests that global economic weakness is abating, consistent with an earlier improvement in monetary trends.

The forecasting approach employed here relies on the Friedmanite rule that changes in the real money supply lead economic activity by about six months. Confirmation of the message from the monetary data, however, is sought from an indicator derived from the OECD's country leading indices. This transformed indicator provides an earlier signal than the raw indices, with a typical lead time of about three months.

Six-month expansion of the global (i.e. G7 plus emerging “E7”) real narrow money supply slowed in late 2010 and early 2011, warning of current economic weakness. It has recovered, however, since May, consistent with economic momentum bottoming in November. Confirmation of such a scenario required an upturn in the G7 plus E7 leading indicator. This was duly delivered in the September update released today.
The leading indicator, admittedly, remains in negative territory, implying that economic news will remain soft into year-end. One of its advantages, however, is that trend changes tend to be sustained – there is a good chance that the September improvement will be followed by further gains. This would be consistent with the steady acceleration of real money over the summer.

The G7 / E7 breakdown of the indicator shows, unsurprisingly, relative strength in emerging markets – the E7 component rose for the fifth consecutive month in September. Interestingly, this continues a recent pattern of the E7 indicator leading changes in G7 momentum and suggests that these economies are now playing a driving role in the global cycle.

Rises in the leading indicator tend to be associated with stronger investor risk appetite – the September increase is consistent with recent better equity market performance.
The E7 indicator is at a level suggesting a rise in emerging market equities.

The pick-up in the E7 indicator mainly reflects the dominant Chinese component.

A revival in E7 momentum would be expected to be associated with a recovery in commodity prices.