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A monthly GDP estimate derived from data on services and industrial output fell by 0.2% between February and March, the smallest decline since October – see chart. The slower pace of contraction is consistent with better purchasing managers’ survey results in March; PMI readings continued to improve in April.

The monthly estimate was 0.3% below its first-quarter average level in March, suggesting that second-quarter GDP figures – released in late July – will show a further decline. Based on current PMI readings, however, this could be smaller than the 0.6% fall implied by the Bank of England’s latest Inflation Report forecast. The Bank is projecting a further contraction of 0.3-0.4% in the third quarter.

Today’s numbers confirm a 1.9% GDP fall between the fourth and first quarters, with the expenditure breakdown showing broad-based weakness. A silver lining, however, is that destocking rose further to reach 2.0% of the level of GDP – the highest on record in quarterly data going back to 1955. A slowdown in stock liquidation will provide important support to the economy later in 2009.

Provisional April monetary statistics released today do not include new information on the MPC’s favoured broad money aggregate – M4 excluding deposits of “intermediate other financial corporations”. On the basis of the data provided, however, this measure is likely to have grown moderately last month.

Headline M4 rose by just 0.1% in April but the release notes a negative impact from a fall in repos with “other financial corporations”. To the extent that this decline reflected transactions with financial intermediaries, it will not affect the MPC’s adjusted M4 measure. Without the repo change, M4 would have grown by 0.5% last month, or about 6% annualised.

The Bank of England’s gilt purchases were reflected in a large public sector contribution to M4 growth in April – “net sterling lending to the public sector” amounted to £30 billion or 1.5% of M4. This boost, however, was partly offset by weakness in private sector sterling credit and a large fall in “net other assets”.

Overall, the figures – while incomplete – are slightly disappointing and support the MPC’s decision to expand the QE programme.

The recession probability indicator discussed in earlier posts signals that the UK economy will return to growth by early 2010. The indicator is less gloomy than the latest Bank of England Inflation Report and suggests that the Treasury’s forecast of a 1.25% rise in GDP in 2010 is achievable. However, a full recovery – in the sense of trend economic growth or higher – will require faster monetary expansion.

The indicator estimates the probability of the economy being in a recession three quarters ahead based on a range of monetary and financial inputs, including inflation-adjusted broad and narrow money supply growth, companies’ liquidity ratio, three-month LIBOR, the yield spread between corporate and government bonds, share prices and the effective exchange rate. A recession is defined as an annual fall in GDP – a stricter interpretation than often employed.

The recession probability estimate began to climb in the second half of 2007 and reached a peak of 91% at the end of 2008 in the wake of Lehman’s collapse – see chart. It fell back to 71% in the first quarter of 2009, however, and a further decline to 33% is indicated for the second quarter, using the latest values for the inputs.

Allowing for the nine-month lead, therefore, the indicator suggests a two-thirds chance that annual GDP growth will be positive in the first quarter of 2010. In other words, any further near-term decline in output is likely to be recouped in late 2009 and / or early 2010. By contrast, the latest Inflation Report fan chart appears to imply only a 40% chance of positive annual growth in the first quarter of 2010 (precise figures will be available tomorrow).

The indicator’s output can also be expressed as a mean forecast for annual GDP growth three quarters ahead. Based on the latest input values, the forecast for the first quarter of 2010 is 0.7%. The Treasury’s projection of 1.25% GDP growth for 2010 as a whole therefore appears reasonable, barring an economic relapse later next year.

The fall in the recession probability estimate has been driven by declines in short-term interest rates and the effective exchange rate and – more recently – firmer real money growth, a rally in share prices and narrower credit spreads. With little scope for short rates to move lower, however, and sterling finding a floor recently, further improvement is likely to depend on stronger monetary trends.

It would be surprising if the expanded £125 billion QE programme – equivalent to 8% of the adjusted M4 money supply – failed to produce a monetary pick-up. Provisional April broad money figures published on Thursday will provide more information on the impact of recent official gilt purchases.

The recent bear market in equities has been unusually severe. It has also been unusually short by the standards of previous big bears. This suggests that a period of base-building will be necessary before markets can embark on a sustained recovery.

The table compares the fall in the Dow Industrials between October 2007 and March 2009 with the seven biggest bear markets of the last century. The peak-to-trough decline of 54% exceeds every prior downturn except the depression bear of 1929-32, when prices slumped by 89%.

The falls in the six other bear markets ranged from 45% to 52%. Prices seem to find a floor after a decline of about a half. This was true even in the 1929-32 bear: after a 48% drop between September and November 1929, equities rallied by 48% before embarking on a further prolonged slide. A recovery from the levels plumbed in March this year was, therefore, predictable.

If the bear market ended in March, however, it will have been only 17 months in duration – five months less than the shortest of the twentieth century bears. This implies that there may be more work to do on the downside – in terms of time if not price – before a sustained advance can begin.

Some of the prior bear markets show little resemblance to the recent decline. The 1909-14 and 1937-42 downturns were influenced by world wars. A repeat of 1929-32 is unlikely – policy mistakes made in the early 1930s have so far been avoided.

The respected financial and economic analyst Tony Plummer argues that equities experience severe bear markets at the end of 30-year economic cycles. He suggests comparing the recent decline with the 1919-21 and 1973-74 bears, which also occurred around 30-year cycle troughs. (Equity market behaviour around the 30-year low in the 1940s was distorted by the war.)

There is also a case for comparing the recent decline with the 1906-07 bear, which was associated with a major financial panic and extreme banking system distress. As Plummer notes, the failure of the Knickerbocker Trust Company in October 1907 and the subsequent policy response, orchestrated by J P Morgan, contain many parallels with events surrounding Lehman’s bankruptcy last autumn.

These three bear markets (i.e. 1906-07, 1919-21 and 1973-74) bear a close resemblance, with equities declining by 45-49% over 22-23 months. The chart provides a comparison with the recent decline. Equities undershot the historical range in early 2009, probably reflecting fears of banking system nationalisation, but have since returned to a level consistent with the prior bears.

If these three earlier cycles are a guide, equities are unlikely to embark on a sustained advance before August / September. Until then, prices may consolidate their recent gains or – in a worst case scenario – retest the March lows. The 50% peak-to-trough barrier, however, provides important support.

The latest Inflation Report is downbeat and will douse recent hopes that the recession is nearing an end. The MPC is arguably too gloomy, particularly about the balance of risks to activity, and may be underestimating the potential boost to the economy from its expanded QE operation.

Key points:

• The central-case GDP forecast is significantly weaker than in February – see chart. This reflects both a lower-than-expected first-quarter outcome and a slower recovery in 2010-11, with the MPC more concerned about credit supply constraints than in February (odd given improvements in the last credit conditions survey).

• The central-case path – estimated from eyeballing the fan chart – implies further falls in GDP in the second and third quarters followed by marginal expansion in the fourth quarter and first quarter of 2010. Trend-like growth resumes in the second quarter of next year. GDP returns to its peak level only in early 2012 – a year later than in February.

• The central-case path is notably weaker than the Treasury’s Budget forecast. The fan chart implies annual average GDP changes of an estimated -3.9% this year, +1.0% in 2010 and +2.6% in 2011 versus the Treasury’s -3.5%, +1.25% and +3.5% respectively.

• Cleverly, however, the MPC has concealed the extent of its difference with the Chancellor by expressing its gloom partly in a negative risk skew to the central-case forecast. The mean projection, taking into account this skew, appears to be for GDP growth of only 0-0.25% in 2010 and 1.5-1.75% in 2011 – far below Mr. Darling’s assumptions.

• The MPC underestimated the inflationary impact of sterling’s plunge and has revised up its near-term CPI projections. The change, however, is modest: inflation averages an estimated 1.6% in 2009 in the central case versus 1.4% in February. Currency effects are judged to be offset by a wider margin of spare capacity and a larger fall in household energy tariffs than assumed in February.

• Longer-term inflation projections have also been revised higher but remain below 2% as far as the eye can see. The central-case forecast for the first quarter of 2012 is an estimated 1.6% versus 1.1% in February. The MPC may be lowballing the numbers in an effort to keep inflation expectations anchored against a backdrop of QE and fiscal profligacy.

The surge in British Retail Consortium sales growth from an annual 0.6% in March to 6.3% in April can be explained by Easter timing effects. The last such timing discrepancy (i.e. Easter falling in April in the current year but in March in the prior year) occurred in 2006. Annual sales growth rose by 8.2 percentage points between March and April 2006 – much larger than this year’s 5.7 pp increase.

While the April numbers are badly distorted, high-street spending has nevertheless proved resilient in recent months: the official retail sales volume index rose by 1.0% (not annualised) in the first quarter. Economists have suggested various reasons, including lower mortgage interest bills, the VAT reduction, falling energy prices and larger consumer cut-backs in other areas (e.g. car buying and eating out).

Monetary analysis offers an alternative explanation: the liquidity squeeze has been focused on companies rather than households so economic weakness has been driven by capital spending rather than consumption. As the chart shows, inflation-adjusted growth in “retail” M4 – i.e. currency in circulation and retail bank deposits – has picked up since late 2008 and tends to lead high-street sales.

While stable consumption is helpful, an economic recovery requires a reversal of recent cuts in corporate spending. Corporate money trends, however, remain weak: M4 holdings of private non-financial corporations fell by 1.7% in real terms (i.e. relative to the RPI) in the year to March. The MPC’s expanded QE operation will, hopefully, boost aggregate M4 growth and thereby corporate liquidity in the months ahead.

Earlier posts argued that the MPC and consensus were underestimating the inflationary impact of exchange rate weakness (e.g. here). Recent figures have indeed been worse than expected: annual CPI inflation averaged 3.0% in the first quarter versus a 2.7% projection in the February Inflation Report. The MPC will reportedly revise up its forecasts in the May Report released on Wednesday.

However, stability in sterling’s effective index since late 2008 – if sustained – promises a reduction in imported inflationary pressures later this year. The annual increase in manufactured import prices may already have peaked at 16% in December (March figures are due tomorrow) – see first chart. Base effects suggest a big slowdown in late 2009 barring another sterling accident.

April CPI numbers next week will benefit from cuts in household energy tariffs. In addition, the British Retail Consortium’s food and non-food price indices registered lower rates of change in April than March and correlate reasonably closely with the corresponding CPI goods components – second chart. Slower food price gains were also suggested by April producer input cost numbers – third chart.

Growth in M4 excluding “intermediate other financial corporations” – the best measure of the broad money supply, also referred to as “adjusted M4” – rose slightly during the first quarter but remains below a level likely to be consistent with trend economic expansion and on-target inflation over the medium term. The latest figures probably influenced the MPC’s decision this week to expand QE.

Annual growth in adjusted M4 edged up from 3.5% in December to 3.9% in March – see first chart. The recovery is more impressive in real terms: deflated by retail price inflation, the annual change has moved up from a low of -0.7% in September to 4.3% in March. This supports expectations that the economy will stabilise during the second half.

Adjusted M4, however, probably needs to grow by 6-7% per annum over the medium term to be consistent with the inflation target. This assumes potential GDP growth of 2% and a decline in velocity of 2.5% pa, in line with the mean over 1992-2004, when inflation averaged close to 2%. Faster expansion than 6-7% is arguably warranted shorter term to support additional economic growth to close the current large output gap.

During the first quarter alone, adjusted M4 grew at a 5.4% annualised pace. This is higher than a 4.0% increase in M4 excluding all financial corporations (i.e. M4 held by households and non-financial corporations). The difference may partly reflect a boost to money holdings of financial institutions (i.e. excluding intermediate OFCs) from the Bank’s QE gilt purchases in March. Detailed figures show significant rises in M4 deposits of securities dealers and investment / unit trusts during the first quarter, partly offset by a fall in insurance companies’ and pension funds’ cash.

Credit expansion is weaker than monetary growth. The annual increase in M4 lending excluding intermediate OFCs (and adjusted for the effect of securitisations) slid further to 2.8% in March from 4.6% in December, although the quarterly change recovered from -2.0% annualised to 2.3%. A key reason for expanding QE is to prevent the slowdown in credit from pulling down monetary growth.

It is difficult to disentangle demand and supply effects on credit weakness. One indication of supply restriction, however, is that credit utilisation rates (i.e. the proportion of arranged facilities actually drawn down) rose further in most industries during the first quarter – second and third charts. Banks are honouring existing lending agreements but appear reluctant to sanction an expansion of credit lines.

Previous posts have discussed the possibility of a V-shaped “Zarnowitz” rebound in global industrial activity – e.g. here. A sharp recovery in new orders indices in the latest round of purchasing managers’ surveys is consistent with the early stages of such a pick-up – see first chart. For the scenario to develop, however, credit conditions must ease and solid monetary growth must be sustained.

As expected, the April Federal Reserve survey of senior bank loan officers showed a reduction in the net percentage reporting a tightening of lending standards on commercial and industrial lending. The fall was smaller than in the equivalent UK survey but larger than in the ECB’s Eurozone poll. The US reading suggest a stabilisation of industrial output over coming months but needs to improve further to be consistent with a strong recovery – second chart. This is likely if the recent better tone in credit markets is sustained.

The Fed survey also reported a big decline in demand for commercial and industrial loans, which some commentators interpreted as a negative economic signal. This slump, however, is probably connected with heavy destocking, as well as a fall in borrowing to finance share buy-backs. The stocks cycle is now turning, lifting activity and potentially credit demand, while buy-backs are of limited relevance for economic prospects. In any case, credit trends tend to follow not lead output – commercial and industrial loans and the ratio of consumer installment credit to personal income are components of the Conference Board’s US lagging economic index.

Credit weakness is of concern only if it translates into slower growth in the money supply, which leads the economic cycle (M2 is included in the Conference Board’s leading index). Annual growth in G7 real narrow and broad money measures stood at 11% and 7% respectively in March, suggesting ample liquidity to support a strong economic recovery. Shorter-term trends, however, are less favourable: US M2 rose at an annualised rate of just 2% in the latest 13 weeks, while Eurozone M3 contracted between December and March – third chart.

For a Zarnowitz scenario to play out, money measures need to reaccelerate. This is more likely in the US, where the impact of weak credit demand may fade and the Fed’s bond-buying operations will continue to provide a boost, than in Euroland, with the ECB still refusing to embrace QE. (Purchases of covered bonds of €60 billion announced yesterday amount to less than 1% of Eurozone annual GDP and the ECB appears to be planning to sterilise the impact on the monetary base.)

The recent rebound in business surveys was presaged by a rise in the equity earnings revisions ratio (the difference between the numbers of analyst upgrades and downgrades expressed as a proportion of the total number of estimates) – fourth chart. The recovery in this ratio has stalled in recent weeks and, like the money numbers, bears close watching: any relapse could signal less favourable business survey results over the summer, possibly associated with another “growth scare” in markets.

The MPC’s announcement of an expansion of QE has come earlier than expected but is warranted by recent news – particularly the disappointing money numbers for March discussed in an earlier post.

The Bank of England will expand its QE operation from £75 billion to £125 billion by extending the current buying programme by a further two months to early August. Purchases are running at about £25 billion a month, with the total currently at £52 billion. The MPC has scope to boost the programme by a further £25 billion within the existing £150 billion authority granted by the Treasury.

The MPC’s statement sounds more hopeful on the economy, noting “promising signs that the pace of decline has begun to moderate”. This suggests that next week’s Inflation Report will retain the optimistic recovery profile shown in February – the MPC’s forecasts could be similar to the Treasury’s, which have been widely ridiculed. CPI inflation has recently been well above the Bank’s projections but the statement claims that a fall below the 2% target is still likely later this year, reflecting favourable food and energy price effects and a sharp easing in pay pressures amid rising economic slack.

Even after today’s expansion, the UK’s QE operation is smaller than the equivalent US initiative. The Federal Reserve is committed to buying up to $2 trillion of securities by the end of 2009, equating to 14% of US annual GDP. The Bank of England’s new £125 billion target amounts to 9% of UK GDP.