Posts here late last year suggested the consensus was too fixated on US recession risk and was neglecting a possible sharp slowdown in Europe. This was based partly on my monetary leading indicators, which were signalling more expansionary conditions in the US.

The US economy has shown greater reslience than most economists expected but the forecast seemed to be going awry in early 2008, with Eurozone GDP climbing at a 3.2% annualised rate in the first quarter versus 1.0% in the US. However, the Eurozone figures were distorted by several factors and little if any increase is expected in the second quarter. Meanwhile, available US evidence suggests GDP grew by about 2% annualised last quarter.

This week’s purchasing managers’ surveys offer further support for the notion that the US now has greater momentum. The first chart shows a weighted average of new business indices from the manufacturing and services surveys – this indicator is usually a good coincident indicator of quarterly GDP growth, with readings below 46 suggesting economic contraction. Soaring energy costs contributed to a general softening of confidence last month but the Eurozone indicator has now crossed beneath its US counterpart. Within Euroland, the Spanish (and Irish) indicators are now deep in recession territory. The UK is also flirting with contraction.

Since late last year my favoured scenario has involved a fall in annual G7 industrial output growth to 0-1% by mid 2008 followed by a US-led recovery during the second half. However, mounting weakness in Europe was identified as a key risk to the forecast.

As the second chart shows, the scenario has played out well during the first half but the expected second-half recovery could be aborted by the recent further surge in commodity prices – this risk was also discussed in previous posts criticising the Fed’s excessive policy easing. This is not yet my forecast but higher input costs will restrain any reacceleration in the US economy while exacerbating weakness in Europe.

Economists who argued late last year that the credit crisis would lead to a hard landing and deflation in 2008 have been very wrong. The global economy has been much more resilient than they expected and the risks stem not from deflation but the inflation caused by the Fed’s excessive rate cuts, which those same economists cheered on.

Despite the credit crisis, global monetary conditions have remained expansionary in recent months – G7 real broad money is currently rising at a 7% annual rate versus only 1% for industrial output. True, money supply numbers have been inflated by a rerouting of financial flows through the banking system but the money / output growth gap would still be positive even without this effect – see chart.

“Excess” liquidity is typically channelled narrowly into a fashionable investment theme – the late 1990s TMT bubble was a classic example – and commodities are currently the speculation of choice. The Goldman Sachs energy index soared 37% last quarter while non-oil prices climbed 7%. The Fed’s aggressive policy easing since last autumn has provided more fodder for the bulls: commodities are being bought as a hedge against a weaker dollar, while US rate cuts have fed through to looser monetary conditions in many emerging economies, sustaining strong growth and rising demand for raw materials.

In the early spring it looked as if equity markets would benefit from an influx of liquidity as risk aversion moderated from the extreme levels reached at the height of the credit crisis. However, a solid rally in April and early May aborted as commodity prices scaled new heights, fuelling renewed worries about economic prospects.

Commodity price appreciation coexisted with rising equity markets over 2003-2007 because costs were climbing gradually from historically low levels. However, the rate of ascent has accelerated sharply since the Fed began to cut rates and prices are now reaching levels that threaten to render a significant portion of the capital stock uneconomic. Meanwhile, large rises in headline inflation rates have prompted a tightening of global monetary policies, further increasing downside risks to growth and earnings. Pressures are strongest in emerging economies: official rates are rising in 22 of 46 investable countries monitored by New Star.

A fall in commodity prices – particularly energy – is therefore a prerequisite for a sustainable rally in equities, both to free up available liquidity and to stabilise the economic outlook. The key issue is whether prices are now at levels likely to result in an excess of supply over demand over the medium term. In the case of oil, they probably are – significant demand destruction is now occurring in developed economies (e.g., US petroleum consumption fell an annual 4% in the first quarter), while a recent lifting of subsidised prices should lead to greater conservation efforts in emerging countries. However, the timing of any reversal is uncertain.

The central case scenario of a recovery in equity markets during the second half as recent commodity price gains partially reverse depends on global liquidity conditions remaining benign. While G7 annual real money growth currently remains strong, nominal money trends have slowed in recent months and a further rise in headline inflation will squeeze the real measure. With industrial activity languishing, however, the money / output growth gap should remain positive, though smaller than in early 2008.

The volume of interbank borrowing contracted in April and May despite the introduction of the special liquidity scheme (SLS) by the Bank of England on 21 April.

The SLS is designed to improve access to funding by expanding the pool of high quality collateral against which banks can borrow. However, Bank of England figures released yesterday show that the stock of borrowing from other UK banks – both unsecured and in the form of sale and repurchase agreements (repos) – fell by £23 billion in April and May combined. The annual growth rate of such borrowing has plunged from 24% to zero over the last year – see first chart.

The contraction of activity despite the introduction of the SLS may reflect two factors. First, from the demand side, the scheme has probably had little impact on the cost of borrowing for most banks, reflecting its LIBOR-related fee structure combined with large “haircuts” imposed on the value of banks’ securities.

Secondly, from the supply side, banks’ unwillingness to lend to each other may be more the result of a shortage of capital and associated pressure to shrink balance sheets than concern about counterparty credit risk, which the SLS seeks to address.

Capital constraints and continuing interbank funding difficulties are likely to be associated with a further significant slowdown in broad money and credit growth over coming months, increasing the risk of a recession (see here).

The prospect of a major lending slowdown is confirmed by figures on unused credit facilities, also released yesterday. Credit expansion has recently been supported by borrowers drawing down existing lines but these are not being replaced by new loans. The stock of unused credit facilities contracted 6.3% in the year to May – see second chart.

My ECB-ometer model indicates a 55% probability of a 25 bp increase in official rates at this week’s meeting. This compares with 30% last month and a small probability of a cut as recently as May – see chart.

The move above the 50% trigger level reflects a further deterioration in inflation indicators together with the hawkish shift in last month’s policy statement. Consumer price inflation rose to an annual 4.0% in June. An average of the past and future price balances in the monthly consumer survey reached a record high last month.

The model suggests inflation concerns will just outweigh worrying weakness in activity indicators. The latest purchasing managers’ surveys are consistent with GDP growth of only about 1% annualised while consumer confidence has slumped to a five-year low.

The 55% reading hints at a significant split on the Governing Council and suggests M. Trichet will play down the possibility of further rises in his press conference remarks.

Markets are discounting two quarter-point rises in Bank rate over the next 12 months but an analysis of recent monetary developments suggests current policy settings are already restrictive against the backdrop of the ongoing credit “crisis”. Monetary trends are not yet signalling a contraction in economic activity but recession risk is rising and is higher than at any time since the early 1990s.

Current inflationary problems partly reflect excessive monetary buoyancy over 2005-2007, when the broad measure M4 was allowed to grow at a 12-13% annual pace. To return CPI inflation sustainably to the 2% target, M4 expansion needs to fall to 6-8% pa. (This assumes trend GDP growth of about 2.5% and a decline in M4 velocity of 2-3% pa, in line with the average over 1992-2004, when inflation was close to 2%.) However, it is also important to avoid undershooting this range, thereby exacerbating current economic weakness unnecessarily. Such an undershoot was a feature of the prolonged early 1990s recession.

Annual M4 growth was still up at 10.0% in May but – as explained here – the headline figure has been inflated by a rise in money holdings of certain financial corporations, which may be acting as a conduit for interbank business. Stripping out these corporations, M4 rose by an annual 8.8% in March – the latest available date – versus 11.8% for the headline measure. Assuming the gap has remained stable since March, May’s headline increase of 10.0% implies growth in the adjusted measure of about 7%, or 2.5% in real terms (relative to RPIX) – the lowest since 1999. (June figures for adjusted M4 will be available in early August.)

Of particular concern is recent weakness in corporate money trends, since empirical evidence shows that companies’ decisions about investment and hiring are sensitive to changes in their liquidity. From a peak of 16.1% in May last year, annual growth in M4 holdings of private non-financial corporations (PNFCs) slumped to just 1.0% in April. By contrast, PNFCs’ bank borrowing has continued to expand rapidly (an annual 14.7% in April), partly reflecting diminished access to other forms of credit. These divergent trends have resulted in the corporate liquidity ratio (i.e. money holdings divided by borrowing) falling below 50% – its lowest level since the early 1990s. Sub-50% readings have occurred on six previous occasions over the last 40 years and in every case business investment subsequently contracted.

Narrow money measures have yet to confirm the worrying message of the broader aggregates. Empirically, “non-interest-bearing M1” – comprising notes and coin in circulation and non-interest-bearing deposits – has the strongest correlation with future output growth. Annual growth in NIB M1 fell well below inflation before each of the three recessions since the mid 1960s but is still higher currently (8.5% in April). However, shorter-term trends are less reassuring: the aggregate is little changed over the last six months, implying a contraction in real terms.

The chart below shows annual GDP growth together with the output of a simple forecasting model based on the above monetary measures as well as interest rates, the effective exchange rate and a measure of credit spreads. The model predicts GDP three quarters in advance and would have signalled the last three recessions. Based on the latest data, it suggests annual GDP growth will fall from 2.5% in this year’s first quarter to just 1.2% by the first quarter of 2009. Taking into account historical forecast variability, this implies a 16% probability of a recession – defined strictly as an annual contraction in GDP – by early next year. The model uses headline M4 growth rather than the adjusted measure discussed above, reflecting a lack of long-term data for the latter. If recent values of adjusted M4 are substituted for the headline numbers, forecast GDP growth falls further to 0.7% in the first quarter of next year, boosting the implied recession probability to 28%.

Market fears of higher interest rates are understandable given that CPI inflation may approach 5% later in 2008 and will remain well above the target until the second half of 2009 (see here for a discussion). However, it is too late for the MPC to affect this prospect and it would be a mistake to try to compensate for policy laxity over 2005-2007 by adopting too restrictive a stance now. As argued above, current monetary trends are consistent with inflation returning to target in 2010 and beyond. If money growth continues to slow over coming months, the MPC should consider easing policy further, even while inflation and inflation expectations remain high, to avoid an unnecessary recession.