In the bleak midwinter

THE Bank of England rarely moves interest rates in December. But on December 6th the central bank, under Mervyn King, its governor, broke with habit and brought down the base rate by a quarter-point, from 5.75% to 5.5%. Shortly afterwards, the European Central Bank (ECB) kept its benchmark interest rate unchanged at 4.0%. The contrasting decisions reflected differing worries in Britain and the euro area about the balance of risk between slowing GDP growth and rising inflation.

Both central banks faced a dilemma. On the one hand, the credit crunch resulting from the worldwide financial turmoil of the past few months will slow growth next year. New forecasts on Thursday from the OECD suggested that growth in Britain would slow from 3.1% in 2007 to 2.0% in 2008; in the euro area from 2.6% to 1.9%.

On the other hand, recent sharp rises in oil and food prices are likely to push up inflation. In a statement accompanying the decision, the Bank of England said that higher energy and food prices were expected to keep inflation above the 2.0% target (it is currently 2.1%) in the short-term. The central bank’s monetary policy committee (MPC) gave warning that “upside risks to inflation remain”.

However, its decision to cut rates was based on its concerns about a slowdown in growth, where it worried about “downside risks” caused by deteriorating conditions in financial markets and a tightening in the supply of credit to households and businesses.

Two recent pieces of evidence had underlined the risk of an abrupt slowdown. On Wednesday a survey of the big services sector reported an unexpectedly sharp drop in business activity, which weakened in November to its lowest level since May 2003. Arguably, the CIPS survey highlighted the central bank’s dilemma, since it also showed a pick-up in price pressures. But it came on the same day that the housing market became enveloped in yet more gloom. House prices fell by 1.1% in November, according to the Halifax index compiled by HBOS, a bank. It was the third month running that prices had slipped.

The clearest signs of deteriorating financial conditions have been in the money markets, where banks lend to each other. The three-month interbank rate is normally a bit higher than the base rate. At the height of the financial crisis in September, it rose to 6.9%. It then dropped a bit, but more recently rose again, to 6.6%.

This three-month rate is an important benchmark for much lending, especially to companies, thus monetary conditions have tightened since the MPC’s November meeting. This is likely to make firms trim planned investments. But the biggest threat is probably from slower consumer spending, the mainstay of the sustained economic expansion of the past decade.

Over the past few years rising house prices have emboldened consumers to save much less than usual. The danger is that a downturn in the housing market will prompt a sudden change of heart as consumers become thriftier and spend less. The sharper the downturn, the more spending will slacken. In 2005, when house prices stalled for a few months, consumption growth slowed to 1.5% and the economy grew by only 1.8%. If house prices fall next year, the damage is likely to be greater.

By contrast, the ECB is managing an economy that has relied much less heavily on rising house prices to fuel consumption. As Jean-Claude Trichet, the ECB’s president, made clear on December 6th, the main worry is about higher inflation, which is currently at 3.0%, well above the target of a bit below 2%, rather than lower growth. Mr Trichet hammered home an uncompromising message that the ECB would not tolerate “second-round effects”, whereby the inflationary impetus from higher food and oil prices leads to an upward spiral in prices and wages.

Financial economists are now expecting the Bank of England to follow through with more rate cuts next year. Judging by Mr Trichet’s comments, the ECB is in no mood to follow suit.