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Cuts in interest rates reduce the opportunity cost of holding money in more liquid forms. Narrow money M1 – currency and checkable deposits – usually picks up relative to broader measures like M2 and M3. This is a sign that the change in interest rates is affecting behaviour and often precedes a recovery in economic activity.

US real M1 typically leads turning points in the economic cycle by 6-12 months – see first chart. Its annual rate of change bottomed in May and moved up sharply in September and October. Recent figures may have been artificially boosted by a flight of cash from money market funds. However, a further recovery in November and December would suggest an approaching trough in economic activity.

Eurozone figures released today also show M1 picking up, with a particularly large rise in October – see second chart. UK data will be available on Monday.

Note that M1 – unlike the monetary base – does not include bank reserves held at the central bank, so is not directly affected by “quantitative easing”.

Revised third-quarter GDP figures released today confirm a 0.5% quarterly decline. From the expenditure side, a 2.4% fall in capital spending contributed 0.4pp to the GDP drop, with consumer spending, inventories and trade each adding a further 0.1pp. The only positive was a rise in government consumption, contributing 0.2pp.

The extent of the weakness in capital spending was surprising given business investment figures released yesterday, showing a decline of only 0.2%. This suggests a large fall in housing investment, consistent with starts data and anecdotal evidence.

National Statistics also released September figures on services output. This series can be combined with industrial production to create a monthly GDP proxy – the two sectors account for 93% of gross value added. The chart below shows quarterly GDP with this monthly indicator.

The July reading of the monthly series was equal to the second-quarter average. The quarterly GDP decline reflected marked weakness in August and September, partly due to the escalating financial crisis. Monthly output fell by 0.8% in August and September combined.

The late-quarter deterioration implies a negative carry-over into the fourth quarter – September output was 0.3% below the third-quarter average. Together with recent very weak business surveys, this suggests a GDP decline of more than 0.5% in the current quarter.

The strategy is to finance a short-term giveaway with a long-term rise in income taxes. It is doubtful that this will amount to much of a “stimulus” to spending and activity.

The changes to national insurance were a major surprise, raising £3.8 billion in 2011-12. Other measures targeting top earners will garner a further £2.2 billion in that year.

The economic forecasts underlying the fiscal projections are optimistic – GDP falls by just 0.25% in 2008-09 and 0.5% in 2009-10 before climbing 2% in 2010-11 and 3% in 2011-12. This implies a mild recession by historical standards, against emerging evidence.

A key risk is that the economy has not regained sufficient momentum by 2010 to withstand programmed large tax rises. Government debt will embark on an explosive path if these increases are postponed.

The VAT cut contributes to the annual RPI change moving deep into negative territory – minus 2.25% by September 2009. However, a rapid rebound is then forecast, to 2.5% in September 2010, with the VAT reversal and higher excise duties contributing.

Servicing the growing debt eats significantly into resources – debt interest is forecast to rise from 1.3% of GDP in 2009-10 to 2.5% in 2012-13. The risk is of a larger increase as huge near-term borrowing needs put upward pressure on real yields.

Total debt issuance by the Debt Management Office is now projected at £161 billion, more than double the Budget forecast of £79 billion. The authorities have rejected advice to “underfund” the deficit in order to boost dangerously low broad money growth.

Most economists support the government’s plans to expand borrowing over and above the rise entailed by operation of the “automatic stabilisers”. However, a larger deficit does not necessarily imply a “fiscal stimulus”.

A standard economic principle is that most consumers base their level of spending on their income expectations over the long term rather than current earnings. Current income is a key factor only for those households with no savings or unable to obtain credit.

It follows that a temporary tax cut applied across all households and to be paid for by higher future taxes is unlikely to have a significant impact on consumption. Measures targeted at savings-short, credit-constrained households would have a greater chance of success but even in this case the rise in spending of those benefiting would be partly offset by cut-backs by other consumers anticipating lower future post-tax income.

This is not to say fiscal actions financed by higher borrowing can never deliver a short-term stimulus. However, policies must be designed to enhance the economy’s supply potential over the longer term, thereby warranting higher long-term income expectations. Examples include cuts in marginal tax rates, which stimulate entrepreneurship and effort, and public investment in projects promising a high long-term return (e.g. transport infrastructure).

A temporary cut in VAT fails the test of being targeted at households more likely to spend any windfall gain and has no positive impact on the economy’s long-term supply potential. Consumption of higher-value items will rise in the months before the lower rate is withdrawn but fall by exactly the same extent afterwards. The temporarily higher demand will be met either from imports or a rundown of stocks, with no impact on domestic production.

The longer-term “multiplier effect” of this VAT jiggling is likely to be close to zero.

Of course, higher borrowing may also have monetary effects – a rise in the deficit financed by bank borrowing would boost the money supply, thereby representing a “net injection of cash to the economy”. However, the same positive monetary impact could be achieved simply by underfunding the existing deficit, without a need for yet further fiscal “largesse”.

The breakdown of the traditional interbank market has resulted in a huge expansion of secured lending between banks channelled through non-bank financial intermediaries. The money holdings and borrowings of these intermediaries are included in M4 and M4 lending, which have been artificially inflated as a result.

This shift began well before the introduction of the special liquidity scheme (SLS) in April but it is reasonable to assume that most of the subsequent increase in intermediaries’ business with banks has been associated with lending secured on Treasury bills obtained under the scheme.

Between April and September M4 rose by £131 billion, of which £123 billion was accounted for by financial intermediaries. M4 grew by a further £43 billion in October, again probably largely due to intermediaries (no breakdown is available). This suggests SLS usage of about £165 billion by the end of October. This may be an underestimate, since the M4 numbers exclude business channelled through foreign-based intermediaries.

No sectoral analysis is yet available for M4 in October. However, the provisional release contains a split between “retail” and “wholesale” M4, with the retail component approximating to money holdings of households.

Inflation-adjusted retail M4 leads retail sales and overall consumer spending – see chart. Its annual growth rate fell to a new low in October, though has not yet turned negative, as it did in the early 1990s. An optimistic interpretation is that consumption is unlikely to be as weak as during the last recession. However, this is of limited comfort: spending fell in six out of seven quarters in that recession, with a peak-to-trough decline of 3.3%.

Monday’s Pre-Budget Report will be accompanied by a revision to the Debt Management Office’s financing plans for 2008-09. The DMO could support broad money growth by cutting planned gilt issuance and boosting sales of Treasury bills. Unfortunately, there is little sign such action is being contemplated.

When the authorities fund a budget deficit by selling gilts to the non-bank private sector, there is no net impact on the money supply – the injection of funds due to the deficit is offset by a transfer of cash out of bank deposits to pay for the new gilts.

Treasury bills are more likely to be bought by banks than non-banks. When banks provide funding there is no transfer of cash out of deposits held by non-banks so the injection due to the deficit is reflected in an increase in the money supply.

Under current plans the DMO will sell £116 billion of debt in 2008-09, comprising £110 billion of gilts and £6 billion of Treasury bills. Gilt sales have totalled £74 billion in the year to date, implying a further £36 billion by the end of March. The £116 billion full-year target is likely to be raised next week, reflecting a higher official forecast for public net borrowing. Suppose funding of £50 billion will be required over the remainder of 2008-09. If the DMO were to raise this amount by selling Treasury bills to banks rather than gilts to non-banks, broad money – measured by adjusted M4 (i.e. excluding deposits of financial intermediaries) – would expand by about 3%.

Annual growth in adjusted M4 was just 3.7% in September, according to the Bank of England (see chart 1.3 on p.11 of the November Inflation Report). On reasonable assumptions, a rate of increase of 6-8% per annum is compatible with achievement of the inflation target over the medium term. Replacing gilt issuance with Treasury bill sales over the remainder of 2008-09 would offset the impact of credit weakness on monetary growth, reducing the risk of a future inflation shortfall.

Economic models are prone to break down under extreme conditions. My MPC-ometer did not forecast the 150 bp Bank rate cut in November but it did indicate a larger reduction, of 75-100 bp, than expected by most economists – see here.

The December forecast will depend importantly on consumer and business survey results released around the end of the month. However, based on current information, the model suggests a cut of no more than 50 bp. A significant minority of economists expects a larger move, according to a Reuters poll conducted last week.

One property of the model is that the data hurdle for policy easing becomes higher as the absolute level of rates falls. Other factors holding it back from predicting a larger move are the recent further slump in the exchange rate and the MPC’s tendency to concentrate action in Inflation Report months.

Minutes of the November meeting released today indicate the MPC believes a further cut of more than 50 bp is warranted by the Inflation Report projections. However, these projections are subject to revision to take account of the fall in sterling (currently 6% below the level assumed in the Report) and fiscal loosening to be announced in the Pre-Budget Report. In addition, some MPC members argued that staggering a further reduction could help to support confidence as the economy weakens.

G7 three-month LIBOR – a weighted average of individual currency rates – has fully reversed its September / October spike and is now below levels prevailing before Lehman failed. 10-year interbank rates are also at a new low – see chart.

Less encouragingly, the fall in LIBOR has been entirely due to actual and expected cuts in official rates, reflected in a large decline in overnight indexed swap (OIS) rates. LIBOR / OIS spreads remain significantly higher than in early September.

The lower absolute level of rates will support the economy, partly by boosting the disposable income of borrowers whose loans are tied to LIBOR or policy rates. However, banks’ continuing difficulties in raising wholesale funds, reflected in high LIBOR / OIS spreads, will constrain the supply of new credit.

As argued previously, policy-makers need to shift emphasis from official rate cuts to direct measures to boost money and credit, such as underfunding budget deficits, buying private sector assets and guaranteeing lending to firms and households.

Incentivising Northern Rock managers to run down its mortgage book at maximum speed never made sense in a wider financial and economic context – as argued here.

According to the Sunday Times, the government is now seeking Brussels clearance to delay further repayment of the Treasury loan, implying Rock will offer more attractive refinancing terms to its borrowers in order to keep their business. The new approach would presumably extend to the Bradford and Bingley mortgage book.

The article also suggests that the final Crosby report next week will propose a government guarantee scheme for mortgage-backed securities. This could further loosen mortgage supply – but only if the fees are set at a significantly lower level than for the existing credit guarantee scheme.

Let’s see if these reports are confirmed.

Banks need to boost their profitability in order to generate additional capital to support higher lending. Yet a measure of the gap between their average lending and deposit rates is close to its lowest level for at least 10 years.

Recent government-sponsored capital injections were calibrated to provide banks with a buffer against coming loan losses rather than support an expansion of lending. With market capital available, if at all, only on penal terms, banks are reliant on retained earnings to build the additional cushion necessary to support lending growth.

Net interest income is the largest element of banks’ earnings. The chart below shows estimates of average interest rates on banks’ and building societies’ sterling lending to the private sector and their M4 deposit liabilities. The estimates are derived from Bank of England data on effective interest rates on different types of loan and the composition of balance sheets.

The gap between the average lending and deposit rates – the net interest margin – recently reached its lowest level in the history of the data since 1999.

This may understate current pressure on banks’ profitability for three reasons. First, a compression of the margin from 2003 was offset by rapid balance sheet expansion, which is now ending.

Secondly, sterling lending exceeds M4 deposits by £476 billion, with the resulting “funding gap” bridged mainly by wholesale market borrowing. The cost of such borrowing has risen significantly since the credit crisis erupted.

Thirdly, fee income has fallen in reflection of weakness in financial markets.

Cuts in Bank rate may not boost the net interest margin much, if at all. Suppose the average loan rate is linked to Bank rate while the deposit rate varies with interbank rates – this is a simplifying assumption but may contain an element of truth, given government pressure to “pass on” Bank rate cuts and competition for savings. Bank rate cuts that were not fully reflected in interbank rates would then reduce the margin.

The three-month overnight indexed swap (OIS) rate – which measures market expectations of Bank rate – is currently 280 bp below its average in September (the last date in the chart), while three-month LIBOR is only 170 bp lower (based on yesterday’s fixing). Actual and prospective cuts in Bank rate have therefore yet to be fully reflected in interbank rates.

The government is further contributing to earnings woes via the charges levied for its various support measures. The fees on the special liquidity and credit guarantee schemes are significantly higher than for their US equivalents, as is the coupon on government-purchased preference shares. Banks are also partially liable for the cost of recent payouts to depositors under the Financial Services Compensation Scheme.