Hamish McRae: Consumption is now the key to growth and 2006 is shaping up to be tricky

The brick attached to the end of a bit of elastic: the analogy is with the housing market and interest rates. You pull for a while, the elastic stretches but the brick does not move. Then you pull just a little bit more and suddenly the brick jumps towards you.

The brick attached to the end of a bit of elastic: the analogy is with the housing market and interest rates. You pull for a while, the elastic stretches but the brick does not move. Then you pull just a little bit more and suddenly the brick jumps towards you.

For a long time house prices resisted the pressure from rising interest rates but in the past month or so the rises seem to have come to a halt. It seems that the higher rates may have done what the Bank of England's Monetary Policy Committee hoped they would do: put a lid on house prices without having to rise so high as to bring the whole economy to a halt too. The housing market seems to have stopped but retail sales are racing on upwards.

Of course we cannot know yet. The links between the housing market and demand used to be quite direct. Each rise in mortgage clipped a known amount off monthly budgets, forcing people to cut back - and vice versa. Now the link is less direct. Many people have fixed-rate mortgages; people can remortgage and get low-interest windows. Eventually higher rates bite but it takes a while. So the link is more through the wealth effect. Because people see the value of their assets rising they feel they can increase their spending - or if the value is falling, they need to cut back.

All this points to changes in interest rates taking longer to feed through to the economy than they used to. If so, it would explain why growth in consumption has been so strong this year, despite the rises in rates.

This delayed response goes a long way to explaining the strong performance of the economy this year. New figures out yesterday confirmed that gross domestic product (GDP) in the second quarter rose by 0.9 per cent, equivalent to an annual 3.6 per cent. That is a clear percentage point above the long-term growth trend and shows a solid recovery from the period of slower growth a couple of years back (see left-hand graph).

The growth is driven by services, as the middle graph shows. Having a large and successful services sector has helped insulate the economy from the effects of the global downturn, though it is encouraging to see that manufacturing has started to grow again, albeit slowly.

We don't really know what the long-term growth potential of the economy is now. People used to reckon on a 2.5 per cent maximum, but in the past few years the possibility of 2.75 per cent is being talked about. One of the reasons has been the apparently endless ability to generate more service-sector growth. However, no one as far as I know has suggested that the overall growth rate could be more than 3 per cent. So things do have to slow down in the coming months.

On the other hand, the not-too-bad performance of the current account in recent years would give some comfort to the idea that the economy can grow towards the top end of the range. Also out yesterday were the new balance of payments statistics for the second quarter. The trade deficit was enormous, as usual, but the current account deficit, at £6.4bn, is pretty steady at 2.2 per cent of GDP (right-hand graph).

Yes, there must be a balance of payments constraint on growth at some point - the point at which productive capacity lags so far behind domestic demand that imports are sucked in to fill the gap. We hit that constraint in the late 1980s and could do so again. But we don't seem to be there yet.

The big issue as far as the balance of payments is concerned is how secure are our invisible earnings. Traditionally they have been wonderful, pumping out large and growing surpluses year after year. The service sector seems likely to continue to do so. But we are also relying on income from foreign investments, which has soared in the past three years but which traditionally has been quite volatile. I have just been looking at the annual balance of payments statistics for last year: the investment income surplus was £22bn. Without that we would be in serious balance of payments trouble.

So there is an obvious danger that the economy has just become artificially pumped up by borrowing, public and private. The new Economic Outlook from the International Monetary Fund, out yesterday, rather supported this view, being somewhat critical of Gordon Brown's spending and borrowing spree. It is true that government current spending is running 5 per cent up year on year in real terms and that is much faster than the growth of the economy as a whole. But whatever you think about the value-for-money aspect of his spree, the overall fiscal policy taken over the seven years he has been in office has been as least as sound as that of the other large economies. He may have been better in his first period of office than his second ... but at least it is hard to see him having a third spell in the same job, one way or another. But if you are worried about British fiscal policy, take a look at American, or Japanese, or French, or German - and cheer yourself up.

The more fundamental general point the IMF is making is that next year will be a year of somewhat slower growth: still plenty of growth, but just not as much as at present. It has cut its global forecast to 4.3 per cent, a touch lower than it estimated in April, and down from an expected 5 per cent this year. That would still be higher than the long-term trend rate of growth of 4 per cent. The principal risk, looking ahead, is oil.

The various economic models suggest that a $10-a-barrel rise in the oil price knocks a bit more than 0.5 per cent off global growth. I don't think we should be too mechanistic about this, though. What it does do is to hit Asia, the fastest-growing region (with the fastest growing demand for oil) harder that the rest of the world. It is also likely, because this rise in the price is mostly a function of higher demand, rather than reduced supply, that the price will stay high for longer than in the past.

Pull together the performance of the UK economy - strong but slowing soon - and the world economy - strong but slowing - and what do you have?

I think that we cannot rely on strong external demand through next year from the world economy. We may well get it if the IMF is right. Indeed we would get it if there were to be a sharp fall in the oil price. If so that would be great but the risks are mostly on the downside. So we are pretty much on our own. How the UK economy performs will depend to some extent on the final burst of government spending before things tighten next year. But mostly it will depend on UK consumption. The key question: how quickly will consumption respond to a fall in house prices, if indeed we get that?

My guess is that this shift to slower growth will all take much longer than people think. Next year will see some slowdown but nothing dramatic. It is 2006 that may be more tricky.