Hamish McRae: No property boom, no inflation, no rate rises: you've never seen anything like it in your life

The slowdown and the forthcoming interest rate cut. There is a simple story, which we all understand, and a more complicated one, which is more of a struggle to grasp.

The simple story is the housing market has stalled and that has led to something close to a stall in consumption. House prices have been stable, maybe falling a little, for around six months. As a result, equity take-out - borrowing against the value of the home to finance current spending - has fallen sharply. Since that was a major way of financing such spending, retail sales have been growing very slowly. In fact, in some months recently they have fallen.

In the past couple of weeks, this evidence of a slowdown has been compounded by two other factors. The job market has gone soft, with unemployment on the claimant-count measure rising for five months - the longest sequence of increases since 1992. And just last week, suggestions came through that the soft market for goods, as shown in the retail sales figures, had been joined by a soft market for services. The British Chambers of Commerce reported that this slowdown in demand for services, which had previously been pretty strong, started to happen in the second quarter.

You can see this relationship between house prices and retail sales in the first graph: not a perfect "fit" but a pretty good one. The Bank Credit Analyst editors who put the graph together note that even a levelling-off of house prices is enough to depress retail sales. And, of course, you have to acknowledge that the terrorist attack may have more effect on an already slowing economy than it would on a fast-growing one.

Against this background, the widespread expectation now is that the Bank of England will cut interest rates soon, maybe in August. Some of us reckoned that the cut would come later, maybe in October, but as the evidence mounts, the probability of an earlier reduction moves upwards.

However, even if the first cut does indeed come in August, that will not do much for growth this year. The lags are too long. So economists are rapidly rethinking their growth forecasts for the UK in 2005. The lowest I have seen come from Deutsche Bank and Global Insight, which both reckon it will be only 1.8 per cent, with the latter noting that the risks are on the downside. If they turn out to be right, it would make the Chancellor's Budget forecast of 3 to 3.5 per cent look like pre-election spin.

More pertinently, the Budget plans based on this higher growth forecast would be unattainable. The deficit will be higher than forecast, yet again, and next year will see some combination of higher borrowing, higher taxation and lower spending.

All this is pretty much in the public domain. You can have a debate about whether the big number for growth will start with a one or a two, but it is not going to be a three. You can ponder whether the Chancellor will put more stress on tax increases or will try to cut spending plans without too many people noticing. But these are, in Donald Rumsfeld's phrase, "known unknowns". The far trickier thing to get one's mind around is the nature of a world with very low current inflation (amazingly low, in the light of what has happened to the oil price) but a huge amount of asset inflation, not least in house prices. The extent to which prices have diverged from the long-term trend is shown in the right-hand graph.

The important thing to be clear about is that this is a global matter, not just a UK one. Asset prices have been strong just about everywhere; current inflation is low or non-existent just about everywhere. Sure, house prices in Germany and Japan are stagnant; true, the Shanghai stock market has performed badly in marked contrast to the economy. True, too, that some of the asset bubbles have already burst (Australian housing), while others have yet to do so (US housing). But the differences are less remarkable than the similarities, and this leads us into a world that is different from anything we have experienced in our lifetimes. You have to go back to before the First World War to see real similarities with the present - huge international investment flows, near-stable prices, very low bond yields, etc. We may not quite be facing Rumsfeld's "unknown unknowns" but it does feel a bit like it.

At a time like this, it is perhaps best to hang on to a few basics. One is that there are natural self-correcting mechanisms. You can see one starting to take place in the energy market, where there is evidence that the high price may be pushing down consumption. That happened in the 1970s and 1980s and will happen again.

Another is that there is a global economic cycle, and while we cannot see clearly the shape or timing of the next downturn, it is out there somewhere in the future. We tend to forget that because the UK came through the last cycle without any serious interruption to growth.

The third is that if the world's central banks set very low interest rates, some people are going to borrow money and spend it. That is what they are meant to do. In the past that has led to higher current inflation, but that was before the world economy became so global. This time it has led to more demand, but that demand has been supplied, at very low prices, by China. So in the case of both the UK and US, it has resulted in larger trade deficits instead.

This is not going to go on. If you take the gloomy view, articulated among others by Andrew Smithers, who runs a boutique advisory service in London, we are now in a calm before the storm. If you want to take the cheerful one, as do most of the mainstream City economists and the Treasury, some of the adjustments are already taking place and it will be possible to engineer a "soft landing".

Thus, while the Federal Reserve will almost certainly increase US interest rates on 9 August, that may be the last rise of this cycle. Another mildly encouraging note came from the US tax receipts, which were up sharply in the first part of this year, cutting estimates of the fiscal deficit for the future. Another, much needed, adjustment may be under way.

The great question is, how will people behave in this low-interest world? In Japan, very low rates completely failed to boost demand. The ability to borrow very cheaply to buy a home did not encourage people to do so, because house prices were falling. In Germany, consumers are now loath to borrow because their real incomes are falling and so it will be harder to pay the loans back.

In the coming months, the UK will become something of a test-bed. Will cheaper money work? We do know we will have lower rates. We don't know by how much these will boost demand. It is going to be really interesting, though in perhaps a slightly uncomfortable way.

Condemned to setting up home in boxes

With all this concern over property prices, has it ever occurred to you that if our houses are so expensive, why don't we build better ones?

A tough-minded set of answers come in a new paper, "Unaffordable Housing", published by the Policy Exchange think-tank and written by Professor Alan Evans and Dr Oliver Marc Hartwich. They argue that our new homes are the smallest in Europe; that we have the third-oldest dwelling stock in Europe; and that our property prices are now higher than in the US, Switzerland or Japan.

Well, the market may do a bit about the last complaint and I don't think we should be too worried about the second. After all, most people, given the chance, would rather live in a Georgian, Victorian or Edwardian house than the sort of rubbish they put up nowadays. But the tiny size of new homes, the rubbish, should be a real worry.

The authors argue that the core of the problem is land use. Only 8 per cent of our land is urban, half the percentage of the Netherlands or Germany. We have 78 per cent of land in subsidised farming, against a 64 per cent average in the EU. We are making our cities denser by building on suburban gardens, which are an important nature reserve, instead of on low-value farming land. And if you look at where people choose to live, it is low-density suburbs.

The trouble is that people who own homes have a vested interest in keeping them expensive. So they will support planning policies that help them but make it more difficult for new buyers to live in decent accommodation. It is a classic insider/outsider economic dilemma; it happens in New York, too, where planning and rent controls have combined to push newcomers into even worse accommodation than we have to put up with.

The central economic point is that controls have costs. Planning restrictions mean people get less space for their money. We may want such controls but we have to be honest about their effects. Do we want to live in a society where people are crammed into little boxes?