Available evidence suggests the US economy continued to expand in the fourth quarter (e.g. consumer spending rose at a 2.6% annualised rate in October and November). It looks as if the bears who forecast a US recession to start before the end of 2007 will have to roll their predictions into the new year (in some cases for the second year running).

Against this background the 100 bp reduction in the Fed funds rate delivered by the Bernanke Fed since August looks unusually aggressive, contrasting with the central bank's behaviour in prior economic downswings. The Greenspan Fed started to cut rates only two months before the 2001 recession began. In the prior recession in 1990, the first cut coincided with the onset of the contraction.

The speedier response cannot be justified by a more restrictive starting level of rates than in earlier cycles. A reasonable summary measure of policy tightness is the differential between the Fed funds rate and annual growth in nominal GDP. This gap exceeded two percentage points at the time of the first rate cuts in 1990 and 2001 but was close to zero when the Fed eased in August.

Has the Fed’s action supported the economy? The principal effect has been to weaken the dollar and put renewed upward pressure on commodity prices, particularly oil. Reflecting surging food and energy costs, consumer prices rose at a 5.6% annualised rate in the three months to November, squeezing real incomes and depressing consumer confidence. So the Fed has contributed to a likely set-back for consumer spending in December.

Has the Fed taken a risk with inflation? The annual CPI increase hit 4.3% in November and even the ex. food and energy measure has firmed to 2.3% from a recent low of 2.1%. Medium-term consumer inflation expectations in the Michigan survey have returned to their 2007 high of 3.1%. The weaker dollar has contributed to a pick-up in manufactured import price inflation, to an annual 4.6% in November. Even imports from China are now rising in price (up 2.3% on the year).

I think the Fed should have waited for commodity prices and inflation expectations to soften before cutting rates significantly. Premature action has served to boost price risks with little or no benefit to economic activity. The Fed may now find itself constrained from easing further at a time when the economy is looking more vulnerable.

My MPC-ometer model correctly forecast the 25bp December rate cut but indicated a narrow 5-4 vote rather than the 9-0 revealed this morning. The four vote “miss” is the largest since March and compares with an average model error of just one vote since I began to use it to forecast in “real time” in October 2006.

The minutes suggest the Committee was particularly concerned by renewed widening in interbank / Bank rate spreads during November: three-month LIBOR stood at 6.6% at the time of the December meeting. According to analysis presented in the Bank’s Quarterly Bulletin, this increase reflected rising credit risk premia rather than a shortage of liquidity, which was the dominant factor during earlier spread widening in August / September.

The MPC-ometer assesses whether the prevailing level of Bank rate is appropriate given incoming economic and financial news. It implicitly assumes a normal relationship between Bank rate and interbank rates, which are the key driver of borrowing costs faced by households and companies. Under current unusual circumstances, there is a case for using the model to assess the need for a change relative to three-month LIBOR rather than Bank rate. If I rerun the December forecast using the prevailing three-month rate of 6.6% rather than the 5.75% Bank rate, the forecast changes from 5-4 for a cut to 9-0, as actually occurred.

This suggests the next cut could occur as soon as January if interbank rates fail to fall back significantly early in the New Year. Some decline is likely but three-month LIBOR probably needs to move below 6% to justify my current forecast that a move will be delayed until February.

As explained here, I think the economic outlook warrants policy being set to achieve three-month rates of about 5.5% in early 2008.

“Other assets” on the Bank of England’s balance sheet rose by £29.3 billion between 12th September – just before the authorities stepped in to support Northern Rock – and 12th December, the latest available date. Northern Rock itself has claimed to have borrowed a smaller amount from the Bank – the BBC’s Robert Peston quotes a current figure of £26 billion. The discrepancy has led to speculation that the Bank of England has been providing covert support to other distressed banks.

The latest Bank of England Quarterly Bulletin, published yesterday, suggests this is not the case. Table B on page 509 of the Bulletin (page 27 on PDF) gives further details of changes in the Bank’s balance sheet between 5th September and 7th November. “Foreign currency denominated assets” are reported to have risen by £5 billion between these two dates, an increase that will have contributed to growth in “other assets” on the weekly Bank return. There was an identical rise of £5 billion in “foreign currency denominated liabilities” over the same period; both changes may reflect the Bank’s normal provision of banking services to other central banks.

Assuming “other assets” continue to be inflated by about £5 billion by foreign currency transactions undertaken since early September, the weekly Bank return suggests current lending to Northern Rock of about £24 billion (£29.3 billion minus £5 billion), close to estimates emanating from the troubled bank.

Prospects for UK official interest rates in 2008 will depend as much on developments in money markets as the wider economy. I expect a further quarter-point cut in early 2008 followed by a period of stability. However, risks to this forecast lie on the downside.

Economic growth is clearly slowing in response to earlier rate rises and tighter credit conditions but the risk of a recession in 2008 is still small, according to my indicator  – see chart. A key supportive factor is the strength of corporate finances, with retained earnings more than sufficient to finance capital spending. This surplus provides insulation from the credit “crunch” and suggests companies are unlikely to cut investment and jobs on a significant scale. Stable labour market conditions would in turn boost the chances of a “soft landing” for the housing market and consumer spending.

Inflationary pressures may prove stubborn despite a slowing economy. Business surveys show firms are planning price rises in early 2008, while a recent pick-up in household inflation expectations and fall in unemployment may lead to higher pay demands. These pressures reflect earlier monetary buoyancy – broad money supply grew by 13% pa between mid 2005 and mid 2007. Significant inflation relief could be delayed until 2009.

The prospect of a moderate economic slowdown with little change in inflation does not argue for dramatic monetary easing. I think policy-makers need to achieve a fall in the key three-month interbank rate to about 5.5% in early 2008. Assuming money markets normalise, this would be consistent with an official Bank rate of 5.25%, implying a quarter-point reduction from the current level. However, the risks lie firmly on the side of a larger cut, either because the interbank lending market remains dislocated or global economic weakness leads to a sharper slowdown in domestic activity.

The co-ordinated liquidity operation announced by central banks yesterday is promising but questions remain about its implementation. The market response has been muted: three-month dollar LIBOR was fixed just 7 bp lower this morning, while the corresponding euro rate was unchanged.

The Fed’s new “term auction facility” is modelled on the ECB’s three-month repo operations, although the first two auctions will be of shorter maturity (28 and 35 days). The key features are 1) a non-penal, market-determined interest rate, 2) acceptance of a broad range of collateral and 3) borrower anonymity.

However, the ECB’s auctions have not been reflected in greater success in reducing Eurozone LIBOR premiums compared with those in the US and UK. The reason is simple: the ECB has offset its additional three-month lending by cutting back funds supplied in shorter-term operations. Banks' reserves at the ECB have shown little change since the onset of the liquidity crisis.

The success of the new operations therefore depends on them being used to increase aggregate central bank lending to the banking system, not just extend the maturity of existing support. The outcome will be unclear until after the auctions take place, partly explaining the market’s muted response.

One curious feature of the operation is that the ECB will offer dollars to European banks but is not planning additional euro lending. This explains the failure of euro LIBOR rates to match the modest declines in dollar and sterling rates.

Back in October I suggested US housing market pessimism was overdone and activity was probably bottoming. The jury is still out but home sales edged higher in September and October – see first chart. One hopeful sign was an improvement in the home-buying conditions index from the University of Michigan consumer survey. As the chart shows, this indicator rose further to a seven-month high in early December.

Weekly mortgage applications for house purchase have recovered to their highest level since January  – see second chart. There are well-known problems with this series – it is biased towards prime borrowers and may be distorted by people making multiple applications – but the recent upward trend is encouraging.

The collapse in home sales from mid 2005 was preceded by a sharp drop in the housing affordability index calculated by the National Association of Realtors. This index bottomed in mid 2006 and has recovered significantly since the summer, reflecting lower home prices and a large decline in mortgage rates for prime borrowers – see third chart.

Construction indicators have yet to show improvement but the NAHB homebuilders index stabilised in November – December's survey is released next week. While still high, inventories of unsold new homes have been falling for over a year, reaching a 22-month low in October. Homebuilders’ stock prices tend to lead housing starts and may be in the process of forming a bottom. As the final chart shows, a recent rally in the S&P homebuilding index broke the downtrend in place since the summer and prices are now retesting the trend line from above. It would be encouraging if the index finds support at the line; a renewed fall below would signal new lows ahead.