Jim Brooks takes a long, hard look at the British economy and sees stormy – but manageable – times ahead

Despite the decision to keep interest rates pegged at 5%, the market seems prepared for a further upward shift in coming months, and this raises the question as to whether rates will stick above 5% next year, rather than dropping. 
So, most advisers, including ourselves, will be reviewing their assessment of rates going forward.
Research suggests that the real rate of interest – the headline rates adjusted for changes in the value of money – is around the lowest point since the Peasants' Revolt.
Against the background of relative economic stability, low inflation and low interest rates, directors of finance in the public sector will be scanning the horizon for gathering clouds. In terms of the general economic position, these  include:
The US Economy
There are fears the US economy is heading for a slowdown. The current account deficit is a concern, and inflation is above 4%. Recession in the US in itself would create the conditions for recession in the UK. Sterling remains overvalued in relation to the dollar
Energy prices
The burgeoning economies of China and India have helped keep UK inflation low.  The gigantic ‘Christmas' ship delivering goods from China recently is enough to have an effect on its own. These economies are energy-hungry and there will be continuing pressure on world energy prices at a time when the UK is increasingly dependent on energy imports.
Housing market
House prices remain horribly unbalanced. Building societies have responded by increasing their lending limits – to five times salary – and this week, a one is offering mortgages of 125% of the purchase price. There is a theory that when average house prices exceed four times the average earnings in an area, then supply of first-time buyers dries up and the chain of completions slows down. A housing recession would exacerbate the problem of affordable housing
UK unemployment
Both employment and unemployment are rising. This reflects the influx of migrant workers, particularly from Eastern Europe. The question is whether these changes will create upward pressure in labour costs. In the short term, the perception is that an increase in the number of migrant workers will have a damping effect on wages. In the longer term, there is increased demand for services, with consequential inflationary pressures.
An ageing population
We still have much to worry about in terms of pensions and the continuing pressure on public services created by an ageing population. It was pressure on pension funds to match investment portfolios to pension commitments which gave rise to the heavy demand for long-term gilts. This, in turn, created the inversion of the yield curve, and the current imbalance in interest rates.
UK public expenditure
Public expenditure is likely to be under very tight control over the next three years.
The greater priorities will be to keep taxation increases in check – total taxation has been rising – and keep both interest rates and inflation low. The chancellor will wish to inherit stable finances as prime minister, and will be working hard to achieve this.
Jim Brooks is executive director at Sector Treasury Services