An earlier post compared the path of world equity prices in the current economic downswing with average experience in six “soft” and six “hard” landings over the last 40 years. At the time of the post equities were following the historical soft landing path closely.

The first chart below updates the analysis to take account of the recent market plunge (the latest data point refers to Friday’s close). Sentiment has clearly shifted, with current prices implying a high risk of a hard landing. This fits with other evidence of increased economic bearishness: for example, the Intrade US recession probability contract has risen to 70%.

While markets have moved to discount a hard landing, monetary conditions have been easing. As shown by the second chart, our monetary leading indicator picked up further in early January, reflecting lower LIBOR rates. Near-term economic weakness is baked in the cake but monetary factors will be lifting activity later in 2008 and in 2009.

The US economy may yet avoid a recession. The third chart shows that business inventories normally rise significantly before recessions start but are currently at a record low relative to sales. Weekly jobless claims are still averaging less than 350,000 – a rise towards 400,000 is needed to confirm a contraction.

Recession fears focus on the housing market and consumer spending. Interestingly, the S&P homebuilding index held above its early January low amid last week’s equity market carnage. Wal-Mart’s share price – which tends to correlate with retail sales – also remains strangely resilient.

Even if a hard landing is confirmed, the first chart suggests equity markets should find support not far from current levels. Additional considerations are moderate valuations and plentiful global liquidity. Of course, the hard landing average includes some larger declines – nothing is guaranteed – but equities look increasingly attractive in risk / reward terms.

For the last couple of months my ECB-ometer model has suggested a neutral policy stance was warranted by economic data and financial market developments (see here). The statement issued after last week’s ECB meeting retained a hawkish slant but, as the FT has reported, comments from officials this week have been more ambiguous and may indicate the balance of opinion on the Governing Council is shifting.

The ECB-ometer attempts to estimate the average interest rate recommendation of Governing Council members each month. A reading of above 12.5 basis points generates a forecast of a 25 bp rise in the ECB’s repo rate; below -12.5 bp predicts a quarter-point cut. The chart below shows the history of official interest rate changes and the model’s forecasts since the ECB’s inception .

Based on the latest information, the ECB-ometer’s forecast for the February ECB meeting is 0 bp, implying an exactly neutral policy stance. The ECB may be toning down its hawkishness but the model suggests economic news needs to change significantly to warrant hopes of a rate cut. As well as more evidence of a serious slowdown, Governing Council members are likely to require falls in money supply expansion and household inflation expectations before contemplating a dovish shift.

The recent small decline in the euro may indicate the market is sensing a turn in the Eurozone interest rate cycle but a sustained reversal against the dollar probably also requires investors to believe that the next cut in US official rates will be the last for some time.

The first chart below shows updated versions of my soft and hard landing scenarios for G7 industrial output growth. As explained here, the scenarios are based on average performance in prior soft and hard economic downswings over the last 40 years. The new versions have been adjusted to take account of the recent path of output growth.

Economic news will be weak in early 2008 but I think the odds still favour an outcome closer to the soft than hard landing scenario, for three main reasons. First, G7 monetary conditions are loosening, which should provide increasing support for economic activity as the year progresses – see second chart. Secondly, corporate profitability is high by historical standards, which should limit weakness in investment and labour demand. Thirdly, emerging economies should remain strong, reflecting their own loose monetary conditions.

The version of my US recession probability indicator incorporating credit spreads stood at 42% in December – dangerously close to the 50% “trigger” level. However, projecting the indicator forward based on current values of the inputs suggests a decline in recession risk by the summer. The extent of US economic weakness in early 2008 is unclear but prospects of a recovery later in the year are improving.

The key negative factors for the outlook are the “credit crunch” and soaring energy costs. Fed and ECB surveys to be released over the next few weeks will provide important new information on credit conditions. A meaningful fall in the oil price would be a big boost to the soft landing case.

Last August Jim Cramer of CNBC ranted that the Fed had "no idea" how bad markets and the economy were looking. The central bank duly obliged with a 50 bp cut in its discount rate. Sir Stuart Rose of M&S tried a similar trick yesterday when commenting on his company’s woeful Christmas trading results. Thankfully, the MPC held firm.

The economy has slowed significantly in recent months but it is not clear that growth is weaker than the MPC desired when they tightened policy last year. Household inflation expectations and business price-raising plans remain at or above levels that troubled Committee members then. Meanwhile, financial conditions have eased significantly over the last month as interbank lending rates have tumbled and sterling has weakened sharply.

A 25 bp cut remains likely in February but the MPC is right to be cautious given near-term inflation risks.

Today’s downbeat December sales figures from the British Retail Consortium confirm the slowdown in retail spending predicted by our leading indicator – see here. The indicator has weakened further over the last month, reflecting falls in mortgage approvals and consumer buying intentions.

Despite a gathering consumer slowdown, I still think the MPC should and probably will leave rates unchanged this Thursday. As recent US experience has demonstrated, easing policy before inflation expectations moderate is liable to boost price pressures while proving ineffective in stimulating the economy. Consumer inflation perceptions rose to a new post-MPC-inception high in December (before Npower’s recent announcement of 17% and 13% hikes in gas and electricity tariffs) – see chart. Statistical analysis confirms that the MPC takes consumer and business inflation expectations into account in setting rates and it would be a surprise if they ignored this deterioration.

Our MPC-ometer model forecasts a 5-4 vote for unchanged rates at this week’s meeting (four votes for a cut). This also appears to be the consensus view: 51 out of 63 economists polled by Reuters expect no change. By contrast, the respected Sunday Times Shadow MPC has voted 5-4 for a 25 bp cut. (Like the MPC-ometer, the Shadow MPC correctly forecast the December reduction.)

The key factors holding the model back from forecasting a January cut are high household and business inflation expectations and the recent sharp drop in the effective exchange rate. It also takes into account the tendency for the MPC to prefer to move in Inflation Report months. Weakness in activity indicators has not been sufficient to outweigh these factors.

Assuming a 5-4 unchanged vote this month, the model suggests a high probability of a cut in February. There is clearly a chance that the Committee will choose to act early, as it did in January last year. However, with LIBOR spreads and sterling falling, financial conditions have eased significantly since its last meeting, giving it scope to wait for further information before acting again. I think that would be the right decision given troubling near-term inflation prospects.