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With a bursting asset bubble causing house prices to fall, hitting consumers in the pocket and causing spending to slow, what is the sensible central banker to do? The usual policy response to slowing economic growth is to cut interest rates, giving access to cheap money so that the public can spend their way out of the slump. This has occurred numerous times throughout history, most recently after the dot-com boom when U.S. interest rates were slashed from six and a half percent to a low of just one percent, averting a long recession and helping the American economy on its merry way. However, boosting economic growth in this way is only effective when the marginal impact of rate cuts on growth outweigh the impact on rising price levels. There may also be unintended consequences such as the inflation of other, different asset bubbles (such as the current, or not-so-current, housing bubble). When this policy measure fails, and declining interest rates fail to boost growth, we find ourselves in the scenario that is the stuff of central-banking nightmares – the dreaded stagnant growth + inflation = stagflation.

We currently find ourselves on the cusp on just such a period, when difficult decisions regarding growth versus inflation will have to be made. On Tuesday, monthly consumer price inflation (CPI) data was released for the U.K. showing a year-on-year increase of three percent, significantly higher than the 2.6% reading that city analysts expected, and significantly above the Bank of England’s two percent target. The Bank’s quarterly Inflation Report, which was released on Wednesday and eagerly anticipated by analysts, painted a gloomy picture for the U.K. economy through to the end of the year and beyond. It warned that even with base rates unchanged at five per cent., inflation is likely to remain above three percent for most of the next year, returning to trend only in early 2010. A fifty basis point cut in the base rate, which the market had been pricing in until mere days ago, would, according to the Bank, lead to inflation significantly above three percent which would only return to trend in 2011.

However we also keep getting U.K. house price data which is indicative of a very weak market. Survey data from the Royal Institute of Chartered Surveyors (RICS) suggests that around ninety seven percen. of surveyors are reporting house price declines – a record low reading for the survey which started in 1978. Indeed according to the RICS data London, the geographical market which many hoped would be the most resilient to price declines, is currently experiencing the widest price declines since 1994. And while data from the Department for Communities and Local Government points to house price appreciation of around five percent year-on-year in April, the comically inept revealing of Cabinet briefing notes by housing minister Caroline Flint, which warned of house price falls of “at best” five to ten percent but that “we don’t know how bad it will get”, has done little to assuage fears. To quantify one plausible scenario, the market for property derivatives is pricing in a capital decline of seventeen percent by year-end, with properties recovering to only ninety percent of their current values by 2013.

The Monetary Policy Committee now faces the unenviable balancing act of sharply higher inflation driven by surging commodity, food and textile prices versus a slowing economy, driven by rapidly falling house prices. So which risk is greater? It should be remembered that property is not the same as other assets in a number of significant ways, and thus should not be treated as such: most people buy a house not as an investment but as somewhere to live, and a small decline in value will not have hoards of people rushing to liquidate their positions; and, with lending standards in the U.K. never plumbing the depths as those across the pond did, most households will not face the prospect of negative equity – retaining a major incentive to keep interest payments up.

All in all the short term risk of inflation probably marginally outweighs the risks of an economic slowdown. Therefore while one can hope that the price of a 42” LCD TV will not spiral out of control, neither should you expect your mortgage repayments to fall in the next few months.