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.