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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.

Revisions to equity analysts’ forecasts for company earnings often provide useful information on changes in economic conditions. A key indicator is the “revisions ratio” – the difference between the numbers of forecast upgrades and downgrades each month, divided by the total number of analyst estimates. In theory, the ratio should be close to zero when the economy is growing at its trend rate.

The charts below show annual growth rates of G7 and emerging E7 industrial output together with revisions ratios for developed and emerging equity markets. Earnings revisions are clearly a good coincident indicator of the industrial cycle in both the G7 and emerging economies.

The developed markets revisions ratio plunged in early 2008, confirming a slowdown in G7 industrial growth. However, the fall partly reflected large financial sector write-downs and exaggerated underlying economic weakness. The ratio recovered strongly in June: financials remained a drag but higher oil and gas prices led to upgrades in energy company earnings forecasts and other sectors also registered improvements. Geographically, the US ratio was the strongest of the major regions.

The emerging markets revisions ratio shows a similar pattern of exaggerated weakness in early 2008 followed by a significant recovery. The June reading is suggestive of continuing solid growth in the major emerging economies.

Earnings revisions may well show renewed weakness over coming months but the latest numbers are consistent with global economic resilience, as forecast here.

A minority of economists now expects UK official rates to rise over the summer. I remain of the view (now the consensus) that rates will stay on hold but will be guided month-to-month by my MPC-ometer model.

The MPC-ometer correctly forecast the 8-1 vote for no change in June, with ritual dovish dissent from David Blanchflower – see here. With two-thirds of the inputs available for July, the model suggests a hawkish shift but less than would be necessary to generate a prediction of a rate increase. The current reading is consistent with either 8-1 for no change (one hawk voting for a 25 bp hike) or 7-2-1 (two hawks counterbalanced by one dove seeking a cut – no prizes).

Important influences on the final forecast will include consumer confidence and inflation expectations on Friday and the manufacturing and services purchasing managers surveys next week (Tuesday and Thursday respectively). The MPC meeting is the following week and the Committee will have early access to June inflation figures.

While no doubt distorted, the shock 3.5% surge in retail sales in May shows that households are not yet adjusting to the stagnation in their living standards implied by higher food and energy prices, as Mervyn King has argued they must if inflation is to return to the 2% target. Even more worryingly, some consumers may be bringing forward spending in anticipation of future price rises, a possibility that will heighten MPC fears that inflation expectations have become dislodged from the target.

While the sales figures will capture the headlines, however, a further slowdown in money supply growth suggests longer-term inflationary risks are diminishing. M4 rose by 10.0% in the year to May, down from 11.0% in April and the lowest annual increase since February 2005. Corporate liquidity trends have been particularly weak recently (see here), implying worsening prospects for business spending – an offset to concerns about (temporary) consumer resilience.

The risk of a rate rise has increased but monetary trends suggest current policy settings are already sufficiently restrictive.

In yesterday’s explanatory letter to the Chancellor, Bank of England Governor Mervyn King claimed that “pay growth has remained moderate”. The official average earnings index (AEI) excluding bonuses rose by 3.8% in the year to April – equal to the average annual growth rate over the last five years.

The alternative average weekly earnings (AWE) series, however, is giving a less benign message. This measure is based on the same underlying data as the official index but uses a different aggregation methodology. Figures released today show earnings excluding bonuses growing at a 4.7% annual rate in April – well above the official measure and the highest rate of increase since August last year.

With the MPC on alert for “second round” inflation effects, the divergence between the two measures creates a policy headache. It is unclear which is the better guide – National Statistics launched a review of the AWE methodology in February, which was due to report in April but has been delayed. The MPC may be right to emphasise the AEI but confusion over current pay trends increases the risk of a policy mistake.

The letter attributes the overshoot entirely to world commodity price pressures. It is disappointing that there is no acknowledgement of the role of excessive monetary growth in accommodating the impact of these pressures on domestic prices.

Mr. King implies policy settings have been appropriate because money spending grew by 5½% in the year to Q1 2008, in line with its average rate of increase since 1997. However, spending expanded by 6¼% pa in the two years to Q3 2007, when domestic monetary conditions were arguably too loose. This was about one percentage point above a level consistent with achievement of the inflation target. (The deflator for money spending has risen about ½% pa faster than the CPI over the long term. Allowing for trend growth of 2¾%, this suggests money spending should expand by 5¼% pa to hit the 2% CPI inflation target over the medium term.)

Bizarrely, while ignoring the past role of high monetary growth, Mr. King cites a recent slowdown in the broad money supply as a reason for expecting inflation to return to target.

The 12% fall in sterling since last summer is given as a reason for expecting inflation to rise significantly further in the near term. However, MPC members, including Mr. King, have previously expressed satisfaction with a lower exchange rate, arguing that it was necessary to “rebalance” the economy.

Unsurprisingly, the letter implies current official rates are appropriate, balancing upside and downside risks. Any hint of a bias would have raised the question of why rates were not moved at the meeting less than two weeks ago.

An especially shocking feature of today’s figures was the further surge in RPIX inflation (i.e. excluding mortgage interest rates) from 4.0% to 4.4% – 1.9 percentage points above the old 2.5% target for this measure.

Northern Rock appears to be repaying its Bank of England loan faster than projected in its restructuring plan. While good news for Ron Sandler & co., Rock’s rapid shrinkage is exacerbating the current mortgage market squeeze, with negative macroeconomic implications.

The restructuring plan projects a 25% repayment of the BoE / government loan in 2008, implying a reduction from £26.9 billion on 31 December 2007 to about £20 billion. According to a trading update on 12 May, the loan had declined to £24.1 billion by 31 March. More recent developments can be estimated from the weekly BoE return. “Other assets” fell by £7.9 billion between 2 April and last week. As well as the Rock loan, this category includes foreign currency lending, which may have declined by £4 billion over this period, judging from information in the latest BoE Quarterly Bulletin (see p.137). A reasonable assumption is that Rock has repaid a further £3-4 billion since the end of March, implying the outstanding loan may already be close to the £20 billion full-year target.

The repayment is likely to have been funded mainly from mortgage redemptions. The restructuring plan projects a fall in Northern Rock’s share of the stock of mortgages from 7.5% at the end of last year to 3.7% by December 2009, implying a nominal reduction of about £20 billion a year in 2008 and 2009. Economy-wide net mortgage lending totalled in £108 billion last year, of which Rock contributed £13 billion. Its U-turn will therefore cut the supply of mortgage loans by over £30 billion in 2008 compared with last year – significantly worsening the impact of the wider credit “crisis”.

The government may be constrained by EU state aid regulations but a less rapid reduction in Northern Rock’s mortgage book would help to reduce the risk of a severe economic downturn.

As detailed in previous posts (e.g. here), my US recession probability indicator peaked just below the 50% “trigger” level in late 2007. The suggestion was that the economy would be very weak in late 2007 / early 2008 but would just skirt a contraction, as defined by the official arbiter, the National Bureau of Economic Research (NBER).

Two months ago 76% of economists surveyed by the Wall Street Journal believed a recession had started. A new survey published today showed the percentage down to 52%, reflecting recent better-than-expected data.

The NBER places particular emphasis on five indicators in determining whether and when a recession has started: GDP, personal income, employment, industrial output and business sales. GDP is regarded as the single best measure but official figures are available only quarterly. Of the four monthly indicators, the NBER assigns greater weight to personal income and employment because they cover the whole economy rather than just the goods sector.

GDP is currently estimated to have grown at annualised rates of 0.6% and 0.9% respectively in the fourth and first quarters. However, these figures could change significantly when annual revisions are published next month. So it is important to track the other four NBER indicators in judging the likelihood of an official recession determination.

The chart below compares recent movements in a composite index of the four indicators with its behaviour during the last seven NBER-defined recessions. The index is derived by rebasing each indicator to equal 1 in the month of a NBER cycle peak and calculating a weighted average. Reflecting their whole-economy coverage, personal income and employment are assigned a 30% weight versus 20% for industrial output and business sales. The current cycle is measured from October 2007 – the latest peak month for the composite index.

The minimum peak-to-trough fall in the index during the last seven recessions was 1.6% (in 2001). It is reasonable to assume this threshold must be reached for the NBER to call a recession now. As at April, the decline from October stood at 0.6%. So the index is consistent with the message from the latest GDP estimates – the economy is not yet sufficiently weak to warrant a recession determination.

My recession probability indicator is giving an “all-clear” signal for late 2008, based on falls in real interest rates and a steeper yield curve, which are judged to outweigh tighter credit conditions. It may be underestimating the negative impact of recent further energy price gains but I continue to expect the US economy to perform better than many fear in 2008, with greater risk of disappointment in Europe. 2009 may be another story, however.

May consumer prices figures are published on Tuesday but Bank of England Governor Mervyn King will already know whether the annual increase reached the 3.1% letter-writing level. Recent news suggests it did, which may explain the lack of any discussion of monetary policy in Mr. King’s speech to the British Bankers Association this week.

Producer output prices accelerated further in May but the aggregate PPI is not generally a good short-term guide to CPI movements. However, the PPI food component correlates closely with consumer prices of processed food and showed a further large rise last month – see chart. If reflected in the CPI, this would add an estimated 0.12 percentage points to the annual increase – sufficient to reach 3.1% assuming no other changes.

Energy prices will have a further upward effect. Electricity and gas prices fell by 2.1% in May 2007 but should have been stable this May, adding 0.07 percentage points to CPI inflation. Meanwhile, the price of unleaded petrol rose by 4.5 pence per litre against a 3.1 pence increase last May, according to the AA, suggesting a further boost of 0.04 pp.

Recent sterling weakness is another possible source of upward pressure. Manufactured import prices rose a further 2% in April to stand 7% above their level in the fourth quarter of 2007.

A 3.1% CPI reading is not a done deal – “core” inflation jumped sharply in April and may partially retrace the increase in May. It would surprising if the decline were sufficient to offset the above upward effects, however.