Hamish McRae: The days of heady growth are over but how gently will Britain come back down to earth?

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It is extraordinary the speed at which sentiment has shifted. By coincidence - mostly - the timing of the election has matched the shift in mood from a booming economy to one of tougher times ahead. That shift was brought into sharp focus last week by the Bank of England's May Inflation Report.

It is extraordinary the speed at which sentiment has shifted. By coincidence - mostly - the timing of the election has matched the shift in mood from a booming economy to one of tougher times ahead. That shift was brought into sharp focus last week by the Bank of England's May Inflation Report.

In its previous one, the Bank was fretting about the danger of rising inflation. Now it reckons that the danger has receded. As well as cutting its inflation forecast, it cut its growth forecast, predicting 2.5 per cent for the rest of this year before a pick-up in the next couple of years. The financial markets' consensus is now for 2.5 per cent this year, falling to 2.3 per cent next. While one should not take too seriously the fine growth adjustments that the forecasters make month by month, the practical effect on interest rate expectations is clear-cut.

A month ago the balance of market opinion was that the next move in UK interest rates would be up. Now it is that it will be down.

The timing of the first cut is still open: both Bank of America and Credit Suisse First Boston (CSFB) now expect it to come towards the end of this year, while Goldman Sachs thinks rates will stay where they are through 2005. But the timing is less important than the direction. Timing will be determined by events still to come, but it is becoming hard to foresee any event that will actually push rates up.

Behind all this is the wider view that the next few years will be tougher than the recent past. I think most of us realised this, hence the fears that taxes will have to rise during this parliament and that, even with these increases, the Government's spending plans will prove unsustainable. But now the election is out of the way, that perception has sharpened. Some of the general reasons for this are caught in the charts, which come from the economics team at Bank of America.

The first point is that the growth of the economy over the past decade has been largely driven by growth in consumption, which has risen by nearly one-third in real terms (see left-hand graph). Growth in the rest of the economy has been much more muted. The second point is that if you take nominal GDP, rather than real GDP, the big driver has been public spending, which has risen by more than two-thirds (centre graph).

Why nominal, not real? Partly because it is hard to measure the real output of public services and partly because, if you believe the figures, there has been a decrease in their efficiency: a lot more money has been spent but much of that has gone on higher pay, and the real output of the public sector has risen more slowly.

Neither of these two sources of demand is likely to grow so fast during the next five years. Consumption has stalled, with retail sales now falling as people realise they can no longer increase their borrowings safely. House prices have stopped rising but are higher relative to incomes than they were even at the top of the 1980s boom (right-hand graph). They are also higher, on this measure, than in the US. We have been able to sustain these ratios because lower interest rates have cut the cost of finance. But the rises in base rates to date have started to squeeze monthly budgets and will do so more in the coming months, despite the overwhelming probability that this is the top of the interest rate cycle.

Why so? Because lots of people took advantage of the low cost of borrowing a couple of years ago and fixed the rate on their mortgage. Now many of these deals are coming to an end and people who were paying, say, 4 per cent are now facing refinancing at something above 5 per cent. So the rises already in the pipeline have taken a while to have effect but will now increasingly bite. And so the squeeze on consumption happens even if house prices stay stable. You don't need to predict a housing crash to accept that consumption will be under pressure.

Nor will public spending be able to go on rising. Nearly half the jobs created between 2001 and early 2004 were in the public sector - growth financed largely by borrowing. According to the OECD, the fiscal position switched from a surplus of 1.2 per cent of GDP in 1999 to a deficit of 3.4 per cent in 2004. Now as pressure mounts on public finances, the rate of growth in spending will inevitably be much slower. Remember that on the Chancellor Gordon Brown's own figures, much of the increase in public sector output will come from an assumed improvement in productivity. Given the record to date, this will lead to a public sector that feels quite different - one that is under much more pressure. Expect the word "cuts" to start appearing in the newspapers as public sector workers resist these efforts to make them increase their productivity.

Some of this pressure will result in more outsourcing. The fuss over the decision on Friday that the NHS would outsource more operations to the independent sector is an early sign of ructions to come.

All this is inevitable. The issue is whether the authorities can engineer a "soft landing" so that growth can slow gently and without disruption. I don't think it is possible to judge this, except to make the point that we have the huge advantage of monetary flexibility. The last time the UK economy made a hard landing was in the early 1990s, when the UK was part of the European exchange rate mechanism and interest rates had to be set too high for the domestic economy. Now the Bank has the freedom to cut rates as needed. Economists who are more bearish about growth expect a sharper fall in rates. For example, Roger Bootle, writing in the latest Deloitte Economic Review, thinks growth this year will be only 2.0 per cent, but he also thinks that interest rates could be as low as 3.5 per cent by the end of next year.

Meanwhile, it is going to be a twitchy few months as people come to terms with the new cooler economic climate. There are three things to watch. One is what is happening in the shops, the bars, the airports and so on. That, plus house prices, will tell us how quickly consumption is falling away.

The second is the monthly run of public finances: is the deficit steady or will slower growth make it widen? And the third is the external situation, in particular oil prices and US demand.

As long as the world economy keeps growing, it will be a lot easier for the UK to make a gentle transition from the boom of the past decade to the more cautious years ahead.

Spend some euros to save La Dolce Vita

Italy is in recession again. That of itself might seem unremarkable, for so too is the Netherlands. And while the German economy has perked up remarkably in the first three months of the year, it too is expected to fall back this summer.

But the problems of Italy are particularly poignant given the country's enviable position as having arguably the highest quality of life in the world. So is there a clash between the good life and economic progress?

The case for gloom is easily made. In Italy there is clear evidence of a deterioration in competitiveness. The figures show that costs per unit of output have risen faster than in France or Germany. You can see it in the difficulties of some large firms, most notably Fiat, which has just negotiated to get $2bn (£1.1bn) from General Motors so that GM can escape an unwise obligation it entered into in 2000 to take Fiat over. And you can see it in the number of highly qualified young Italians who have left the country to work in the UK and US.

Set this alongside such delightful innovations as the "slow food" movement - where cities turn their backs on the US market-driven approach to economics (and fast food) and plump instead for leisure - and you might believe that pleasure and efficiency cannot co-exist.

Mercifully, there is a much more positive case to be made. First, the problems of Italy are quite specific. Part is regional, for the efficient north still has to subsidise the less-efficient south. Part is structural, for Italy has been relatively slow in building up the new service industries to replace the inevitable decline in manufacturing. And part has to do with taxation and benefits, which encourage early retirement and discourage people from entering the labour market. Italy has an exceptionally small proportion of people of working age actually in jobs.

Because it is easy to identify these problems does not mean it is easy to solve them, but it is a start. Couple that with the clear areas of excellence of Italy - in high-tech engineering as well as the better-known dominance of fashion and quality craft industries, and in tourism - and you can make a case that strategically the country is well-placed. It can do so many things other countries can't. So don't write off Italy at all - and go and spend some money there this summer to help pull it out of recession.

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