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Monday’s post expressed concern about a recent sharp deterioration in business and consumer surveys. The February Philadelphia Fed survey of regional manufacturers, released yesterday, was another shocker, with the expected new orders index plunging into negative territory – a rare occurrence. As the chart below shows, this suggests further weakness in the national ISM survey to be released on 3rd March.

This morning’s “flash” Eurozone purchasing managers’ surveys were more reassuring, however, with the manufacturing new orders index only slightly lower than in January and the services new business index recording a surprise recovery. It could be that the Eurozone surveys are proving slower to pick up emerging economic weakness but it is also possible that the slide in US confidence has been exaggerated by the Fed’s panic rate cuts, which suggested the central bank believed a recession had started.

The Philadelphia Fed survey does not resolve the recession issue. The expected new orders index has fallen below zero on five previous occasions since the survey’s inception in the late 1960s. In four of the five cases a recession followed but in two of these it began more than a year later. In one case – 1995 – the economy skirted recession.

Nor is the survey’s weakness necessarily a signal of further equity price falls ahead. In the five prior instances of expected new orders turning negative, the average change in the S&P 500 index over the subsequent six calendar months was +8.8%. The change was positive in four of the five cases, the exception being 1973 – but this was in the context of the orders index continuing to plunge to a record low of -43.

What are the implications of the continuing surge in commodity prices?

The first implication is that there is no shortage of global liquidity available to chase a “hot” investment theme. This is consistent with the current large gap between G7 real broad money supply growth and industrial output expansion – see chart. As I have argued previously, this gap is helping to cushion the effect of credit tightening on economies and markets.

Secondly, the commodity surge supports my view that Fed easing has been counterproductive, serving to boost inflationary risks rather than stimulate the real economy. The Fed should have waited for inflation expectations and commodity prices to soften before cutting rates aggressively.

Thirdly, the squeeze on G7 real incomes implied by rising commodity costs will sustain current economic weakness. However, I still think a recession / hard landing can be avoided and momentum will improve later in 2008 as looser monetary conditions offset credit tightening. More on that soon.

Last week’s Inflation Report was regarded as slightly hawkish but I was struck by the forecast based on unchanged interest rates, showing an annual CPI increase of just 1.77% in the first quarter of 2010. Despite two rate cuts and a sharp fall in sterling, this was only 3 bp higher than the two-year-ahead forecast in November’s Report and represents the second largest shortfall from target in the MPC’s history.

The message was reinforced by today’s minutes of the February meeting, showing an 8-1 vote in favour of the quarter-point cut, with David Blanchflower dissenting in favour of a 50 bp move. This is considerably more dovish than the 5-4 split suggested by both my MPC-ometer and the Sunday Times Shadow MPC.

In light of this information, and ongoing deterioration in credit markets, I now expect an early further cut in rates despite the prospect of a surge in CPI inflation to 3% by the third quarter of 2008. I will be guided by the MPC-ometer but a move seems likely before the next Inflation Report in May.

My personal view is that rates should be held at 5.25% until inflation is over its hump. The MPC’s mandate is to meet the 2% target “at all times” not just at the two-year horizon. It is true that its policy actions have a negligible effect on near-term inflation prospects but they are relevant one year ahead, when the Inflation Report suggests the annual CPI increase will still be well above target, at 2.29%.

A large divergence has recently opened up between survey-based measures of economic activity and “hard” data released by official statistical insitutions.

The hard information has been holding up reasonably well, examples last week including US retail sales and industrial output and Japanese and Eurozone GDP. As the first chart below shows, G7 industrial output growth has been following my soft landing scenario closely.

Surveys, by contrast, have deteriorated sharply over the last month, in some cases to an extent suggesting recession. For example, the earnings revisions ratio from the IBES survey of equity analysts plunged to a seven-year low in February – see second chart. Marked weakness was also on display in reports last week on US consumer sentiment, US small firm optimism, Japanese consumer confidence and German investor sentiment.

Under normal circumstances survey-based information provides a useful lead on hard economic data. However, sentiment weakness may have been exaggerated by negative credit market news and the Fed’s “emergency” rate cuts, which suggested the central bank expected a recession.

I am inclined to give greater weight to the hard data but will be concerned if the deterioration in sentiment is sustained and confirmed across a wider range of surveys. In the Eurozone, this week’s “flash” PMI readings will provide an important litmus test.

The extent of near-term global economic weakness is unclear but I still expect an improvement later in 2008 as recent monetary loosening offsets tighter credit conditions.

The UK authorities have been unhappy with the use made of the weekly Bank of England return to estimate the Bank’s lending to Northern Rock and are proposing to abolish it.

Central bank transparency is an important principle that should not be discarded lightly. The claimed benefit of increased operational flexibility is dubious.

A letter to the Financial Times opposing this change can be found here.

I am away for a few days and will post again next week.

The statement accompanying last week’s UK rate cut referred to elevated inflation expectations as posing an upside risk to medium-term inflation prospects. However, some economists argue that survey-based expectations measures provide little information about future inflation, with activity indicators playing a much more significant role.

To test such claims, I examined the statistical relationship between consumer price inflation one and two years ahead and measures of confidence and inflation expectations from the monthly European Commission surveys of households and manufacturing firms. The inflation measures are shown in the first chart below. (They are based on percentage balances of households and firms expecting higher prices.)

To summarise the results, inflation expectations of both households and manufacturing firms are useful for forecasting CPI inflation one year ahead but lose power at the two-year horizon. When combined with confidence measures, manufacturing inflation expectations retain significance at the one-year horizon but household expectations contain little additional information.

These results argue for caution in cutting rates any further until business inflation expectations subside but the MPC should be less exercised by high household expectations, at least while consumer confidence is weakening and there is limited evidence of pass-through to wages.

The MPC will use this week’s Inflation Report to signal its intentions. A useful summary measure of its bias is the mean inflation forecast two years ahead assuming unchanged rates. The November forecast, at 1.74%, was further below the inflation target than in any previous Inflation Report since the MPC’s inception, a clearly dovish signal – see second chart.

With Bank Rate down by 50 bp since November, and sterling’s effective rate 7% weaker, the new forecast is likely to be much closer to the 2% target. The extent of any negative deviation will indicate the Committee’s residual easing bias following last week’s cut.

There is a scare story doing the rounds about US banks “running out of cash at the Fed”. This is based on the Fed’s H.3 statistical release, showing that “non-borrowed reserves of depository institutions” (second column of table) turned negative in the latest fortnight.

The story revolves around a misunderstanding. The Fed supplies cash reserves to the banking system either via sale-and-repurchase agreements (repos) or lending from the discount window or more recently under the Term Auction Facility. Only repo-sourced reserves are classified as “non-borrowed”.

Banks have recently taken advantage of the TAF to source their needed reserves so repos have fallen, pushing non-borrowed reserves into negative territory. However, total reserves have remained stable (first column) and above the level dictated by reserve requirements (third column). There is no aggregate shortage of cash at the Fed. Banks have chosen to use the TAF because they can obtain longer-term funds against a wide range of collateral.

If there were any shortage of cash the fed funds rate would be trading above the Fed’s 3.0% target. It has been below the target on average so far this week.

Fear levels are about as high as they get when such stories are taken seriously.

Today’s decisions by the MPC and ECB were refreshingly boring.

The MPC cut Bank Rate by 25 bp and issued a balanced policy statement referring again to the opposing risks posed by slowing growth and elevated inflation expectations. Unlike the ECB, the MPC does not use these statements to signal its intentions, which will be communicated in next week’s Inflation Report.

The ECB statement retained references to upside inflation risks and a need to “monitor very closely” all developments but indicated heightened uncertainty and greater concern about the outlook for economic activity. The changes were marginal but consistent with the view that events are playing out similarly to early 2001, in which case rates are likely to be cut some time in the second quarter – see last post.

I have updated the ECB-ometer forecast for tomorrow’s meeting, last discussed here. Despite elevated inflation indicators, weakness in yesterday’s services PMI and last week’s consumer survey have contributed to a fall in the “average interest rate recommendation” from -2 bp to -6 bp. While insufficient to generate a forecast of a rate cut (recommendation of below -12.5 bp required), this suggests the ECB should now have an easing bias.

The ECB’s behaviour in 2001 may provide guidance on how the central bank will manage a shift from its current hawkish stance to an eventual rate cut. In January 2001 the policy statement in the ECB’s Monthly Bulletin talked of “upside risks to price stability which warrant close monitoring” – a similar formulation to that used in recent press conferences. The February Bulletin retained a reference to “close monitoring” and upside dangers but stated that “risks to price stability … appear more balanced”. In March “close monitoring” was replaced by an assurance that the Governing Council was “firmly committed to price stability”. This in turn was softened to “will continue to focus on maintaining price stability” in April, after which the repo rate was finally cut by 25 bp in May.

As now, inflation was a constraint on early action in 2001, with the annual increase in consumer prices hitting a high of 3.1% in May, the month of the first cut. The ECB-ometer’s forecasts also looked similar in early 2001 – see chart. One key difference was the euro, which had fallen significantly against other major currencies in 1999 and 2000.

If 2001 is a guide, the ECB may begin the shift towards easing by modifying tomorrow’s statement to indicate that risks to price stability remain on the upside but are diminishing because of slowing growth. This would be consistent with an eventual cut some time in the second quarter. A more dramatic shift in language is probably needed to signal the possibility of earlier action.

Two important pieces of US economic news have been released over the last 24 hours.

The first was the Fed’s quarterly survey of senior loan officers, conducted during the first half of January. As expected, this reported a further significant tightening of credit standards across all types of loan. The first chart below shows an indicator of corporate credit conditions derived from the survey. (It is an average of the percentage balances of officers reporting tighter standards on commercial and industrial loans to large / medium and small firms.) This indicator has warned of recessions historically by moving through 35. The latest reading is just below the “trigger” level.

The second chart plots the corporate credit conditions indicator together with a measure of the slope of the Treasury yield curve (the gap between the three-month Treasury bill rate and the average yield on bonds of over 20 years’ maturity). An inverted yield curve signals restrictive monetary conditions and is usually associated with a tightening of credit standards. The curve has been steepening recently, suggesting credit conditions could ease, though probably not until the second half of 2008.

The second piece of news was the ISM non-manufacturing survey for January, which reported shocking declines in current activity and new business. The third chart shows GDP growth with a weighted average of the ISM non-manufacturing new business and manufacturing new orders indices. The relationship is far from perfect but the ISM indicator suggests a contracting economy in early 2008.

Recent data have been weaker than I expected but a self-reinforcing downturn is not inevitable. Inventories are low, net exports should remain supportive and companies have yet to announce large-scale layoffs – see fourth chart. Loosening monetary conditions and fiscal stimulus suggest any decline will be short-lived and conditions will improve as the year progresses.