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The inflation surge of the 1970s is widely acknowledged to have been caused partly by insufficiently restrictive monetary policies following the 1973 oil “shock”. Are policy-makers similarly at risk of “accommodating” the inflationary impact of higher commodity prices now, as they simultaneously seek to minimise economic weakness caused by credit market woes?

The rise in oil prices in recent years has occurred in two distinct stages, which mirror the two shocks of the 1970s, although the primary driver has been emerging world demand for energy rather than supply disruption. The initial breakout from the range of the prior decade occurred between late 2003 and mid 2005, when prices rose from $35 to $65 a barrel (expressed in terms of today’s US consumer price level). A period of stability then ensued until early 2007, when prices embarked on a further surge to their recent peak above $140. For comparison, inflation-adjusted prices rose from $13 to $45 during the 1973 oil shock (caused by an Arab embargo on supplies to allies of Israel) and from $45 to a peak above $110 in 1978-79 (as the overthrow of the Shah led to sharp fall in Iranian exports).

A simple way of measuring the monetary policy response to an oil price change is to compare subsequent movements of short-term interest rates and headline consumer price inflation. As the chart below shows, average G7 short rates failed to keep pace with inflation following the 1973 shock – real rates were consistently negative over 1974-78. This policy response is now recognised to have been misguided: it allowed higher inflation expectations to become entrenched and did not avert a severe recession. By contrast, short rates were raised well above the level of inflation after the second shock of 1978-79, partly under the influence of hawkish US Fed Chairman Paul Volcker. Recession again ensued but the restoration of monetary discipline laid the foundations for a sustained decline in inflation during the 1980s.

How does recent experience compare with these episodes? The 2003-05 oil price rise was less dramatic than the 1973 shock and had a much smaller impact on headline inflation. As the chart shows, G7 short rates moved up in line during the shock and became significantly positive in real terms in 2006 as inflation fell back. On this basis, policy appears to have been broadly appropriate, although the Fed should arguably have been swifter to tighten in 2004-05 – low real rates contributed to the subsequent housing market bubble. The response to the more recent oil price surge has been less convincing. The Fed’s decision to prioritise credit market concerns and ease policy aggressively coupled with a larger rise in headline inflation than in 2003-05 has resulted in G7 real short rates becoming significantly negative. As in the mid 1970s, it is debatable whether policy laxity has served the intended purpose of supporting activity and it may have contributed to an unwelcome rise in inflation expectations.

It is possible to argue that G7 monetary policies are tighter than suggested by the level of real short rates because of the impact of the credit crisis on banks’ lending behaviour. However, the interest rate measure used in the chart is based on interbank rather than policy rates so partly incorporates current market dislocation. Moreover, any assessment of the global monetary stance must also include emerging economies, where banks are generally still lending freely and short rates are even further below inflation. Taking these considerations into account, there appears to be little scope for any early decline in global rates if inflation is to be returned to the low levels of the last decade. Indeed, a rise may be required – led by the US and emerging economies where real rates are heavily negative – to ensure sufficient monetary discipline.

M4 and M4 lending jumped sharply in June but the increases were largely due to “other financial corporations” (OFCs) and may reflect distortions caused by the Bank of England’s special liquidity scheme. Excluding OFCs, M4 rose by 6.4% in the year to June, the lowest annual growth rate since 2000 – see first chart.

Corporate liquidity trends are particularly concerning: M4 holdings of private non-financial corporations (PNFCs) fell for the fourth consecutive month, while their liquidity ratio (cash divided by bank borrowing) slumped to a new 17-year low, with negative implications for future business spending – see second chart.

This is not a time for hawkish heroics. The MPC should hold rates at next week’s meeting and be prepared to ease later in the year if these money trends continue.

Contrary to consensus expectations, the US has held up better than other major economies since the credit crisis erupted last summer.

The first estimate of US second-quarter GDP is released on Thursday. According to Reuters, economists expect quarterly growth of 2.0% annualised (I think a stronger number is likely). If realised, this would imply a year-on-year increase of 2.1%.

Available evidence suggests the Eurozone and Japanese economies contracted in the second quarter, partly as pay-back for exaggerated strength in the first three months. Assume optimistically that GDP is unchanged on the quarter in both cases. This would imply year-on-year growth of 1.7% and 2.0% respectively.

UK second-quarter numbers released on Friday showed year-on-year GDP growth of just 1.6%.

Stopped-clock pessimists now expect a US recession to start during the second half. They will be right one day but I expect the economy to stay afloat, based on loose policies and low inventories – likely to have fallen further in the second quarter. Downside risks look much greater in Europe.

Since the credit crisis erupted commentators have frequently speculated that the Bank of England has advanced funds outside the framework of its normal money market operations to banks other than Northern Rock. There is no evidence from available sources of any sterling lending of this sort. However, the recently published Bank of England Annual Report shows that the Bank substantially increased its foreign currency lending to banks during its last financial year.

According to the Report, “loans and advances to banks” by the Bank’s Banking Department rose by £32.2 billion between 28 February 2007 and 29 February 2008 (from £31.6 billion to £63.7 billion – see note 10 on page 66). The weekly Bank Return indicates that the Banking Department’s money market operation loans (“sterling reverse repos”) were little changed between the two dates, while the Report also states that lending to Northern Rock stood at £24.3 billion on 29 February 2008 (note 29, section a) on pages 82-83). This leaves an “unexplained” increase in lending of about £8 billion.

Section d) of note 31 on pages 88-90 confirms that this represents foreign currency lending. Non-sterling “loans and advances to banks” increased by £8.2 billion over the year (from £10.8 billion to £19.0 billion). This was financed by an £8.5 billion increase in foreign currency deposits from other central banks (from £7.0 billion to £15.4 billion).

To a small extent, these rises reflect the currency translation effect of a weaker exchange rate. However, even if all the non-sterling loans were denominated in euros, this would account for only £1.4 billion of the £8.2 billion increase in foreign currency loans.

The “innocent” explanation for this lending is that foreign central banks asked the Bank of England to place foreign currency funds in the market on their behalf. However, it seems an unlikely coincidence that such a large rise occurred during a year when the banking system was under considerable stress.

More probably, the Bank borrowed under arrangements with one or more other central banks to onlend to banks in London facing difficulties raising foreign currency funds in wholesale markets. Such an operation would be similar to the currency swap between the Federal Reserve and the ECB and Swiss National Bank introduced last December and increased in size in March and May, under which the Fed advanced funds to be auctioned off to dollar-short banks in Europe.

Perhaps there is another explanation but this one fits the facts. It seemed strange at the time that the Bank of England was not involved in the announced Fed currency swap facilities. It may have chosen a more “covert” form of lending to avoid drawing further attention to UK banks’ difficulties after the Northern Rock debacle.

Key themes in my outlook for 2008 were 1) global economic resilience despite the credit crisis, 2) US outperformance of Europe and 3) inflationary risks stemming from the Fed’s excessive policy easing.

These themes receive support from the IMF’s latest global economic forecasts, published last week.

The IMF now believes world GDP will rise by 4.1% in 2008, up from 3.7% in April. 4.1% is a respectable number by historical standards – growth averaged just 2.9% over 1990-99.

Among the major economies, the US has received the largest upgrade – growth is now forecast at 1.3% in 2008, up from just 0.5% in April. This could still be too low, with second-quarter figures next week likely to show annualised growth of 3% or more.

Meanwhile, average 2008 consumer price inflation has been revised up by 0.8% and 1.7% in advanced and emerging economies, to 3.4% and 9.1% respectively.

Looking forward, relatively loose monetary policies and solid emerging world momentum should continue to limit global economic weakness. Downside risks stem less from the credit crisis than an inflation-induced squeeze on real incomes.

A key issue is whether US and emerging world resilience is offset by gathering weakness in Europe. Today’s flash PMIs for July show the Eurozone economy was slowing sharply as the second half began – see chart.

$140 oil threatens to abort the expected second-half recovery in US growth. The perennial recession forecasters have another chance of glory – though not for the reasons they suggested.

Markets have responded to mounting gloom by lowering expectations for official interest rates later in 2008 – some economists are even talking again of cuts. Yet excessive Fed easing is the prime cause of the problems the economy now faces.

As the chart shows, the Goldman Sachs commodity price index stabilised from mid 2006 as the Fed moved its target Fed funds rate above 5%. The explosion upwards started only when the Fed went into reverse and cut rates aggressively from last autumn. Prices have risen by over 60% in less than nine months – equivalent to the gain over the prior three years. Posts here in late 2007 and early 2008 argued that the Fed’s policy was misguided and would fuel inflation rather than stimulate the economy.

Commodity prices – particularly energy – may now be above the level needed to equate demand and supply over the medium term. Markets that overshoot fundamentals sometimes fall back to earth just under the weight of their overvaluation. More usually, a tightening of monetary conditions is necessary to trigger the adjustment. For example, the TMT bubble of the late 1990s burst only after the Fed raised official rates from 4.75% to 6.5%.

The Fed has damaged the economy by buckling to the demands of Wall Street interest rate doves. A commitment to a stable dollar, backed up if necessary by policy tightening, would be the best route to a recovery. More of the same is a recipe for continuing woes.

I am on annual leave for the next two weeks so MoneyMovesMarkets will be taking a break. Please check back in late July.

Two weeks ago my MPC-ometer had a slightly hawkish tilt, suggesting an 8-1 vote for unchanged rates at this week’s meeting, with one member seeking a 25 bp increase – see here. However, the forecast has changed significantly as a result of 1) a downward revision to first-quarter GDP growth, 2) very depressed consumer and producer confidence readings for June and 3) falls in share prices and short-term gilt yields. The model now suggests a 6-3 outcome, with three doves voting for a 25 bp cut.

These are testing times for the -ometer as well as the MPC. With inflation overshooting, it is possible the MPC will assign greater weight to price indicators and less weight to activity data and financial markets than on average over its 11-year history – the period over which the model has been estimated. If so, the 6-3 forecast will exaggerate the Committee’s easing bias – the 8-1 vote by the Sunday Times Shadow MPC may prove closer to the mark. However, any error will be used to improve the predictions for subsequent months in two ways: first, the model is reestimated monthly so the weights will be adjusted in light of the July outcome; secondly, the prior month’s vote is included as an input so a less dovish result in July will feed back into the forecast for August.

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 resilience 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.