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.