The Nationwide house price index for December was 18% below the peak reached in October 2007. The chart updates a comparison of the current decline with the house price busts in the early 1990s and mid 1970s. (The Halifax index does not extend back to the 1970s.)

The projections assume that 1) inflation-adjusted house prices follow the same path from their peak as in the 1990s or 1970s and 2) retail prices move in line with consensus expectations, derived from the Treasury’s monthly survey of forecasters. The last actual number in the chart is an estimate for the first quarter assuming a further 1% fall in prices from their December level.

The current decline continues to track the 1990s bust closely. An exact replication would involve a further 15% fall in prices from their December level to a trough in the first quarter of 2011. The slightly milder 1970s bust would imply an 11% decline to a low one quarter later.

Cuts in interest rates were constrained in the 1970s and 1990s by high inflation and ERM membership respectively. On the other hand, mortgage credit availability may have deteriorated to a greater extent in the current cycle – although inflation-adjusted mortgage lending contracted significantly in the 1970s. I intend to revisit a comparison of valuations in a future post.

The corporate liquidity ratio – companies’ holdings of short-term assets divided by their short-term borrowing – is a good leading indicator of the economic cycle. A falling ratio may indicate that corporate profits are weakening and / or companies are expanding their operations too rapidly. In either case, future retrenchment is more likely, involving cuts in investment and jobs.

In the UK, the ratio of private non-financial companies’ M4 money holdings to their bank borrowing – a proxy for the liquidity ratio – began to fall significantly as long ago as 2005. It has continued to decline in recent months, matching the low reached in the early 1990s recession. This signals ongoing business contraction at least through mid 2009.

Worryingly, a similar trend is now in place in the Eurozone. The chart shows the ratio of Eurozone companies’ M3 holdings to bank loans with an original maturity of up to five years. This began to decline significantly in early 2007 and is currently at its lowest since 2003.

The higher level of the Eurozone ratio compared with the UK is of limited comfort. Unlike their UK counterparts, Eurozone companies borrow significantly on a long-term basis from their banks – about half of outstanding loans have an original maturity of more than five years. Including these in the calculation would push the ratio well below the UK level.

As in the UK, the decline in the Eurozone ratio initially reflected rapid growth in borrowing but slowing monetary expansion has been the key driver more recently. The annual rate of change of non-financial companies’ M3 holdings fell from 13% in November 2007 to 3% a year later – the lowest on record since 2000.

The appropriate policy response to the corporate liquidity squeeze is Fed-style quantitative action to boost aggregate broad money supply growth. Such measures are required just as urgently in the Eurozone as the UK.

My MPC-ometer model predicted large cuts in Bank rate in November and December but not on the scale delivered. There was a similar divergence in 2001, after the 11 September US terrorist attacks, when the MPC appeared to “bring forward” reductions ahead of an expected deterioration in economic data.

To capture this behaviour in 2001, I included a “dummy variable” in the model, which had the effect of lowering the predicted level of Bank rate in October and November 2001 and raising it over the subsequent four months. Using an identical timing shift variable starting in November 2008 improves the model’s recent forecasting performance.

The 2001 parallel suggests that, having cut rates by more than suggested by incoming data in November and December, the MPC will require compelling evidence of further economic deterioration and / or diminishing inflationary pressures to warrant continuing to ease aggressively in early 2009.

For January, the version of the model including the dummy variable predicts a 25 bp cut. After its late 2008 pyrotechnics the MPC is unlikely to move by as little as 25 bp so the choice is between no change and a 50 bp reduction. I favour the former, on the view that the Committee will regard falls in the exchange rate and interbank / policy rate spreads over the last month as substituting for a further official cut. (The sterling effective index on Friday was 8% below its level at the start of the December meeting, while the three-month LIBOR / overnight indexed swap rate spread was 80 bp lower at this morning's fix.) An additional argument for delaying any further move until February is that fourth-quarter GDP figures and results of the Inflation Report forecast round will then be available.

Interestingly, the Sunday Times Shadow MPC, which often calls the decision correctly, voted 6-3 for no change at its latest meeting.