Hamish McRae: So where do we go from here?

The glitz of a new Parliament; the gloom of a new mood in the economy. Just about every day that passes brings further evidence that the economic slowdown is more marked than people expected.

The glitz of a new Parliament; the gloom of a new mood in the economy. Just about every day that passes brings further evidence that the economic slowdown is more marked than people expected.

Yesterday it was the consumer price figures. These show prices rising at 1.9 per cent a year, which is just below the target. But if you take out volatile things such as food and energy prices, and utility bills, the rise is only 1 per cent. The main reason: retailers are frantically discounting prices to try to retain demand. Retail sales have fallen for a couple of months and, with the housing market stagnant, seem set, at best, to grow very slowly over the coming months.

We all know the reason for this. The housing market has stalled. A lot of our spending is geared to this, not just because we can borrow against property to finance our spending but more directly because when we move home we tend to splash out on new carpets and cookers.

The sudden onset of the slowdown seems to have taken the Bank of England unawares. In the latest Inflation Report it pulled back its inflation forecast and it also reckons that growth will slow to 2.5 per cent this year. That is not bad by European standards but it is well below the Treasury estimates. Last week, launching the report, Mervyn King, the governor, gave the impression the Bank had been taken by surprise by the onset of the slowdown.

So where do we go from here? Well, I think the first and most obvious thing that has changed is the outlook for interest rates. Hardly anyone expects a rise and one City bank, ING, reckons the first cut will come in August. There is a real danger that the Bank has made an error, responding too slowly to developing weakness and focussing too much on unwarranted fears of what might happen to inflation in a couple of year's time.

Let's assume rates will start to come down, if not in August, at least before autumn is out. The question then will be whether this will be enough to keep growth going. Or will the 12-year expansion, the first third under the Tories, the second two-thirds under Labour, draw to its end?

The good news is that a fall in interest rates does not need to push house prices up to give a boost to consumption. All it needs to do is to stabilise prices and increase turnover. As long as it is clear that prices are not falling and there is the possibility that they might rise, would-be buyers might as well get on with it and buy. Once there is activity in the housing market, sales of household goods and services will pick up.

True, there are other weakish signals: for example, car sales are running down this year after near-record sales last year. The numbers of individuals becoming insolvent have shot up in the past few months, unsurprisingly in view of the rise in interest rates and the impact this has had on household budgets. Still, you have to remember that people do like spending money if they have it. So a fall in interest rates - and the prospect of more cuts to come - would be an important crutch for consumers.

The bad news is that while it is possible to be cautiously hopeful about consumer demand it is not easy to be so sanguine about public sector demand. The public sector has been on a huge hiring spree, with the share of total employment rising from 26.5 per cent in 2001 to 28.5 per cent now. But growth is already tailing off and, on the Government's own estimates, it looks as though the size of the workforce will be pegged. Since public sector hiring has been the main driver of the rise in employment, just moving from an increase to a steady state would change the tone of the job market.

Unemployment is exceptionally low. Some modest rise is bound to happen at some stage and we should regard that as normal. But a world where unemployment is creeping up is one that is qualitatively different from one where it is creeping down. It feels different. That affects people's spending patterns. A French official made a fascinating observation about the British economy last week: it was that if people lost their jobs the strength of the economy would ensure that they could find another. The comment was in the context of the French referendum: what guaranteed employment better, a strong system of social support (as in France) or a strong economy (as in the UK)? The inference was that the UK gave people more durable prospects. But, of course, this is only true if the labour market does indeed remain strong and the number of high-profile redundancies coming through is disturbing.

What could ride to the rescue? Do not expect much from export demand. The eurozone takes 46 per cent of our exports and it is treading water. Forecasts for growth this year are at best about 1.5 per cent and at worst not much more than 1 per cent. Two large economies, Italy and the Netherlands, are in recession and Germany has only been kept growing by a non-recurring tax cut in the first quarter. Even France, the least bad big eurozone economy, seems to be slowing.

The US? It takes 18 per cent of our exports but while one should never write off the US consumer, similar pressures to those in the UK are mounting. Interest rates are rising and slower growth is in prospect. So while our exporters remain much more optimistic about US demand than eurozone demand, there is a certain fragility there.

Of the rest, there is really nothing big enough to change the overall picture. So China is going great guns. But China buys just 1 per cent of our exports, so increasing demand there does not really help.

A rise in investment here? It isn't happening. Or rather, yes, investment is going up but far more slowly than in previous cycles. Why is a puzzle. Maybe the figures understate what is happening - economic data often proves wrong, when, years later, it is too late to do anything about it. Maybe companies are inhibited by the rising regulatory burden and by the need to pay money into pension funds. But we cannot be certain investment will carry on rising, especially if consumer demand slackens.

At a time like this, with so many signs of a slowdown about, it is important not to become too alarmed. We share with the other English-speaking economies the ability to pump up demand by cutting interest rates. For a variety of reasons the same mechanisms do not seem to work so well on the Continent or in Japan. Somehow British, American, Canadian, Australian and New Zealand people seem more willing to borrow money and spend it than people of other nations. When the European Central Bank or the Bank of Japan cuts interest rates nothing much happens. When the Bank or the Federal Reserve does so, we hit the shops.