Hamish McRae: Everything seems rosy but are we missing something?

Is it reasonable to expect this sustained fall in relative price of imports to continue?

It is a funny time for the UK economy and at funny times you wonder whether you are missing something.

On the one hand, there seems to have been a modest pick-up in demand (and in house prices) and a strong surge in the stock market, all in a benign inflationary environment. On the other hand, there is a widespread sense of unease that things are not sustainable. The current account deficit is nudging above 2 per cent of GDP, partly a result of strong import demand, partly because the UK has now become a net oil importer. Public finances are stretched, with the fiscal deficit stuck above 3 per cent of GDP, and the growth of the world economy depends largely on the continued enthusiasm of American consumers.

The new Bank of England Inflation Report gives a good backdrop to consider these uncertainties. Its core message, spelt out elsewhere in this section, is that the inflation outlook remains benign, that on balance growth is expected to pick up a bit but the risks, if anything, are more likely to be on the downside. Viewed through the prism of the prospect for UK interest rates, I suppose this means that some modest further reduction may yet be in store but don't count on it soon. More interesting, though, is the handle the Bank's analysis gives on the way the world economy will develop this year, and the place the UK will have in this.

The four graphs come from the report and illustrate one key determinant of the outcome: the resilience or otherwise of the British consumer. As you can see from the first graph, it is possible that the present slight uplift in retail sales will be sustained through much of this year. You may recall that the retailers threw a wobbly over Christmas, reporting great concerns about falling sales and slashing prices. Now it seems that price-cutting worked in that volumes recovered. The Bank of England has a series of agents who report on activity around the country and the first graph shows their reports and retail sales. As you can see, the lines are quite a good "fit", suggesting there will be a solid pick-up in retail sales through the spring. Further support for this comes from the stronger housing market and in particular the rise in mortgage applications.

But any increase in consumption will have to happen against a backdrop of higher taxation. You can see what has been happening in the next graph in terms of the taxation that directly affects household spending. Expect that proportion to nudge further upwards through this year and next. So taxes are leaning against rising consumption as an increasing proportion of the funds that would otherwise be consumed are taken in tax.

The relationship between incomes and consumption is shown in the third graph. Consumption, the red line, has been growing since the early 1990s, though real incomes have occasionally slipped. But since 2000 there has been a pretty steady downward trend in both lines: both real income and consumption are rising at roughly 1.5 per cent a year and it is hard to see why either should perk up in the coming months.

Besides, all of us have benefited enormously from the falling cost of imported goods. Go into IKEA and you can buy a chair for less than the price of your lunch - well, almost. The chair is imported from China, the lunch is not. The remarkable decline in the cost of imported goods and the corresponding rise in the volume of imports is shown in the right-hand graph. The fall in prices has brought a direct benefit to our living standards and we now spend a quarter of our income on imported goods.

But is it reasonable to expect this sustained decline in the relative price of imports to continue? That depends on sterling remaining strong and that in turn depends, partly at least, on whether we can continue charging what we do for our own exports. No one needs to be told that the UK is an expensive place to operate from but we seem so far to have been able to get away with it, more or less.

That in turn leads to the huge question: what is the nature of competitive advantage at the top end of economic scale? Or, more simply, how can we justify our costs? Are we missing something that might suggest that we cannot carry on in this way?

I think there are three main medium-term dangers.

One is that there will be a global slowdown associated with a fall in US consumption and/or a fall in the dollar. The UK economy would be caught in the backwash. The very latest news from the US is bullish: very strong consumption and encouraging words from the new chairman of the Federal Reserve, Ben Bernanke. The US budget, in its initial form, starts to correct the federal deficit, which is good news for international confidence. But the danger will continue.

The second danger is that the UK's competitive position has been eroded, partly by higher business taxation and regulation, but also by the enlargement of the EU to the east. To some extent it has, though it seems to retain a marginal advantage over other western European locations. So far there is evidence of some minor slippage in some financial services but nothing significant. There is a lot of friction here, for firms cannot relocate easily or cheaply. London remains a fashionable place to operate from and has such a huge skill base that jobs could not be easily dislodged. But elsewhere in the UK, the case for continued location is more marginal. As Labour discovered just before the recent Dunfermline election, hundreds of jobs can be lost when a foreign-owned factory decides to close.

That leads to a third concern. The relative success of the UK economy is built on quite a narrow base: financial services, communications, energy, a small top-end manufacturing base, creative services, higher education and... Well, there are others and new specialities are being created all the time. But the UK, as the most open large economy in the world, is very vulnerable to any reversal of the liberal global trading environment. That is not a problem for this year but it might become one in two or more years' time.

The most important graph above is the final one. While the country can continue to buy cheap and sell dear, the rise in living standards can continue to outpace the growth of the economy. But we should be cautious, maybe a little more cautious than we currently are.