A major advantage of a stable economy is the expectation among individuals and companies that stability is the natural order of events, that short and shallow cycles have become the norm.

Under these conditions, for instance, companies may see a downturn in the economy as being temporary, the legacy of a long period of sustained, sustainable growth. Rather than making staff redundant in an attempt to control costs at a time of falling demand, companies may then choose to keep their workforce, expecting demand to pick up relatively quickly.

A tight labour market where skilled staff were at a premium would underline such a decision given the difficulties in recruiting staff with the right skills when the economy improved.

But such labour hoarding will itself be stabilising. One of the characteristics of the UK economy in 2001 and 2002 was that despite two years of below trend growth in GDP, the unemployment rate did not rise.

Partly, this was the result of increased government spending creating jobs in the public sector and of job creation in the service sector.

But there is also a suspicion that manufacturing industry which faced the brunt of the weakness of global demand in 2001 and 2002, did not shed jobs at anything like the rate it would have done a decade earlier, when much sharper fluctuations in activity characterised the UK economy.

Increasing employment and a stable unemployment rate helped keep consumer confidence buoyant during that world slowdown.

Together with the Bank of England’s loosening of monetary policy – the Bank cut rates seven times in 2001, taking Base Rate down from 6% to 4% - this stability in the labour market encouraged consumers to borrow more and to spend more.

As a result, domestic demand remained strong and the UK enjoyed relatively strong GDP growth at a time when world demand and, therefore, UK exports and company investment were weak.

It is too early to say that this was a characteristic of the 2008-2009 downturn in the economy.

The unemployment rate has certainly risen sharply but there are a number of admittedly tentative reasons for thinking that the increase has not been as sharp as it might have been and that the lagged effect might turn out to be less pronounced than in previous recessions. The reasons for this are as follows:

• by the middle of 2009, the UK had not shed jobs as quickly as the US, for example, in spite of a greater fall in output;
• a number of flexible working schemes had been agreed between employers and employees, especially in the manufacture of cars, which reduced the incidence of redundancies;
• by mid 2009, the rate of increase in the claimant count measure of unemployment had eased.

In a low inflation environment, relative price changes are much more transparent. This transparency allows consumers to decide more easily which products/services to purchase.

For most of the post-1992 period, consumer spending was consistently strong and the primary driver of the robust GDP growth. But even in that environment, consumers were selective, shopping around for bargains and often waiting for sales to appear before deciding to spend, especially on big ticket items.

In some areas, notably textiles, clothing and footwear and household goods, volume growth of spending often outstripped value growth to a considerable degree, emphasising the competitive pressure with which many retailers had to cope.

Nor have financial services been immune from this change in culture. Customers have learned to shop around for the best value and this will continue to develop especially as competition and the regulatory authorities demand further price transparency.

Nowhere was this more obvious than in the mortgage market up until 2008 where competitive pressures, sharpened by price transparency narrowed the gap between mortgage rates and Bank Rate.

Low inflation also means that debt takes longer to erode than when inflation is high.

The chart below shows how repayments as a percentage of income decline under different rates of inflation.

The assumption underlying the chart is that, under each inflation scenario, an individual borrows a sum of money, the repayments on which account for 40% of his/her income. The sum of money will, of course, vary to the extent that higher rates of inflation are associated with higher borrowing costs.

The chart shows that when inflation is at 2.5%, it takes over 11 years to reduce the proportion of income taken up by repayments to 25%. When inflation is 5% it takes nearer 8 years to drop to 25% while when inflation is 10% it drops to a quarter within 5 years.

Low inflation and, therefore, low interest rates, allow an individual initially to borrow more for the same amount of repayments.

But, as significantly, it also ensures that the debt retains its importance relative to income for much longer than when the rate of inflation is high. While it allows a bigger initial debt, it inhibits the borrower from topping up that debt for a much longer period. In the current climate, where the average consumer debt is 160% of income, this is a vital consideration.

The term “borrower” can, of course, equally apply to the Chancellor of the Exchequer borrowing on behalf of the public sector or a captain of industry borrowing on behalf of his or her company. The same rules apply. Inflation has often, in the past, come to the rescue of those with high levels of debt.

The boom and bust which characterised the 1970s and 1980s was replaced by a much smoother progression, at least up to 2007. Despite the latest bout of turbulence, inflation targeting is likely to remain (in some form) the anchor of macro economic policy regardless of who wins the next general election.

The chart below provides some evidence of the benefits to companies of low inflation. Profitability, generally, was relatively stable from 1993 up to 2008, with net rates of return for the company sector as a whole moving in a band just two percentage points either side of the long- term average.

The service sector, depending largely on domestic demand, has been the main beneficiary but manufacturing, in spite of having to cope with the variability of overseas demand, has also seen some advantage.

Low inflation, or rather the expectation that low inflation is here to stay, meant that long-term interest rates fell substantially.

This fall was assisted by the decline in government borrowing which resulted from the improvement in public finances in the early years of this decade, the decreased supply of gilts helping to dampen long-term bond rates and to support long-term bond prices.

Institutions such as pension funds, however, still need to hold such instruments to provide safe income streams and this future demand combined with lower long-term interest rates meant that strong companies, prepared to borrow long term in the capital markets, would be able to do so relatively cheaply.

Indeed, the trend, especially after 1998, was for companies to meet their need for external funds from the capital markets rather than borrowing from banks (see Company Finance ).

As a result, the past decade saw a relative decline in the importance of bank borrowing by private non-financial corporations (PNFCs) and a growth in the sector’s dependence on marketable debt and equity finance.

A fall in long-term interest rates serves to make the marketable debt option even more attractive.

A low inflation environment also imposes its own disciplines.

• With low nominal and real growth in demand, significant increases in turnover can only be achieved by increasing market share.
• Moreover this will take place in an intensely competitive environment where price transparency makes it much more difficult for individual companies to increase prices independently.
• Not least it makes cash flows harder to manage and thus increases risk. Firms can no longer look to double-digit inflation to rescue them. There are no easy wins or quick fixes anymore.

For many businesses, this implies a stark choice in terms of their planning.

• If they want to win market share and increase sales volumes, being the cheapest is not an option open to many companies.
• The alternative is to be the smartest, which means either to work more efficiently or to have a product that is a little better than the competition. This ‘added value’ will enable a company to charge a bit extra despite the greater competitive pressures that are part of the low inflation environment.

In an international context it also suggests that companies will not need regular devaluations of the currency to maintain their competitiveness, as was the case in the 1970s and 1980s.

• On the contrary, the UK currently has one of the lowest rates of inflation in the EU and seems likely to emerge from the recession sooner than the major economies in the eurozone. On balance this should mean an appreciating currency as markets recognise the strength of the economy.
• But a strengthening currency increases the price pressures on those parts of the economy exposed to overseas competition, such as manufacturing and agriculture.
• German businesses in similar circumstances in the 1970s and 1980s, responded by increasing investment and focusing on productivity and efficiency. In other words, knowing they could not be the cheapest, they tried to be the smartest.

By no stretch of the imagination can a low-inflation, stable-growth economy be considered an easier operating environment for companies than the old boom-bust. Such an economy should now be seen as a largely neutral factor by companies in their planning.

Businesses no longer have to guess which way general activity will move since growth, inflation and interest rates will all operate within much narrower bands than they did in the past. The difference between success and failure for businesses in the future will be largely down to the quality of the management and the efficiency of the labour force.

Low interest rates and the increased confidence induced by a constantly growing economy led to individuals increasing their borrowing in the short run.

A sustained period of low interest rates was positive for borrowing growth simply because lower interest rates mean reduced repayments. If interest rates effective halve (which they did compared with the 1980s), it means that regardless of income, people can borrow more. And they did.

In addition, some financial institutions appeared to be very liquid and tried aggressively to increase market share. So some parts of the banking system relaxed their lending criteria and levels of personal debt soared. Stability and the associated decline in unemployment engendered a greater confidence in the ability to repay, a sentiment that has now gone into reverse, with household debt at record levels.

The housing market (see Housing), particularly reflected that adjustment, with affordability and the confidence to increase debt levels both helping to drive the market. Other things being equal, this adjustment should continue until house prices, income and repayments have achieved some degree of equilibrium.

That point was reached in 2007, as interest rates turned up at a time when house prices were rising at double digit rates and financial institutions were offering 100% (or more in some extreme cases) mortgages. Affordability reached its limit and the market went into a tailspin.

Once the market recovers (as it is likely to start doing in 2009-10) and equilibrium has been reached, and with low inflation and low interest rates continuing, house price inflation should follow income growth more closely.

• Under these conditions, borrowers would not expect to realise substantial capital gains from the housing market, and so the potential investment benefits from borrowing to finance regular trading in the market would diminish.
• In addition, slowly growing personal incomes reduce the extent to which debt service burdens fall over time compared with a more inflationary environment where larger nominal income increases erode the debt burden.
• These effects should, after a delay, therefore, counter the incentive to increased borrowing created by the low level of interest rates.

The same pattern has been true of consumer credit with a sustained period of economic growth combining with low interest rates and, importantly, a belief that those conditions were set to continue, to boost unsecured (i.e. consumer credit) borrowing. At the same time, the resurgence of house prices for a decade from the middle of the 1990s, plus, for part of the period, the strength of the equity market, has provided a fatter cushion of wealth. Taken together, these elements furnished a comfortable environment which raised confidence levels and encouraged individuals to spend more, and save less, of their income.

The short-term effect of stability, low inflation and low interest rates was to discourage saving and encourage borrowing.

Consumer spending growth has consistently been stronger than income growth since 1995, buoyed by high consumer credit borrowing. As a result, the saving ratio, the proportion of disposable income put aside for a rainy day, fell consistently (see chart 6.6).

Paradoxically, as the recession took a grip, the saving ratio increased. This was largely a reflection of the fact that borrowing fell and so, at an aggregate level, spending dropped below income thus increasing saving. This measure of saving is, however, merely the arithmetic difference between income and spending and is probably best regarded as the ‘non-spending’ ratio.

But low interest rates mean reduced interest income for holders of liquid assets, i.e. deposits with banks and building societies.

• Savers who are aiming for a target income from such savings will, at some stage, therefore, need to increase their nest egg to achieve their required income level.
• Low interest rates may also affect the composition of saving. Low after-tax interest rates on standard savings products are likely to make individuals more concerned to place their savings in assets which offer higher income, although at the cost of accepting higher risk. Accordingly, equity linked savings should become more popular in a low interest environment.
• For annuity holders, reduced annuity rates mean that a greater amount of money will need to be invested in order to achieve a given level of income.

At the same time, low inflation also implies slower growth in asset prices. House prices, for instance, once they have fully adjusted to a new low interest rate/low inflation environment, should increase at a rate closer to income growth, thus removing the temptation for individuals to substitute a sharp increase in asset value for saving out of income.

The transition from a high inflation, high nominal interest rate environment to a low inflation, low nominal interest one has also brought with it a number of specific problems. For instance, the prospect of lower future nominal returns has meant that for some holders of endowment mortgages, final payouts may not be as much as expected, indeed in some instances may not be enough to pay off the outstanding debt fully.

In the medium term, other factors should come into play.

In the first place, there has been a perceived shift in responsibility for welfare provision from the government to individuals, a shift which is clearly seen in the area of pensions. Here the level of support provided by the government has fallen sharply over the last few decades following the decision to index pensions with prices rather than earnings, and is set to diminish further in the future.

To encourage individuals to take more responsibility for their own pension provision, the Government introduced the Stakeholder Pension and the Individual Pension Account, although the evidence suggests that these have been slow to take off. Even so, these and the fact that private pension funds are shifting away from expensive final salary schemes to cash schemes means that some boost to saving may be apparent over the next few years.

The Turner Report published in November 2005 highlighted the fact that the British population is not saving enough to fund a comfortable retirement for future pensioners. There are, in fact, two factors behind that statement.

• The first involves the changing population structure and the size of the pensions pot needed to fund this.
• The second is a question of how to fill the pot.

Demographic shifts mean that the proportion of the population eligible for a pension will increase over coming decades, while the length of time each of us is likely to spend in retirement is also increasing. In short, more people will need a pension and for a longer period of time!

Thus there are a number of medium-term factors which should result in adjustments to savings levels but consumers will probably need a lot of persuasion, especially with regard to the new pension initiatives, before these changes become a reality.

The main feature of savings over the next few years may not be a substantial increase in savings

• but rather a shift in saving patterns away from low return liquid assets towards pension schemes and higher return but more risky products as individuals try to boost income growth
• and a trend to working beyond what is now regarded as the ‘normal retirement age’.