Although UK growth has slowed sharply, there is no case yet for the Bank of England to lower interest rates

The "two-speed economy" is the cliche of the moment. It refers to the contrast between the weak manufacturing and trading sectors and the strong domestic and service ones. The trend from manufacturing to services is long established.

But there are signs that the shift has become unsustainably rapid and the pattern of growth distorted both by the high level of sterling and, more recently, by the slowdown in world growth and trade.

There is little that the Bank of England can do directly about the divided economy. Back in the 1980s, Nigel Lawson, the then Conservative chancellor, was accused by Edward Heath, the former Tory prime minister, of being a one-club golfer. But under a different government and a different chancellor there is still only one club - interest rates - wielded by the Bank's monetary policy committee.

The interest rate weapon is supposed to be directed almost exclusively at securing an inflation rate of 2½ per cent. Under a revised policy, more emphasis could be given to domestic activity or the exchange rate and less to the short-term inflation prospect. The chancellor could, for instance, revert from a single-point inflation target to a range or increase the period of time over which the target has to be achieved. But that about exhausts the possibilities.

Sir Edward George, the Bank's governor, has rather daringly abandoned monetary metaphysics and spoken of the underlying objective of a stable and non-inflationary growth of demand. At first sight this points to an interest rate cut. New second-quarter estimates show that not only has the growth of overall UK output slowed down to an annualised 1¼ per cent but the fall in manufacturing output has also been accompanied by a slowdown in service growth.

The second-quarter estimate of gross domestic product could, however, be misleading. I do not want to place too much emphasis on the effect of foot-and-mouth disease. This now looks less like a distortion and more like a permanent feature. There are more conventional grounds for regarding the GDP estimates as over-pessimistic on demand. For, although they are the most comprehensive indicators we have, they are not up to date.

As the tabloids say in letters several inches high, the Nationwide Building Society reports annual house price inflation this July at 10.9 per cent; and the society's economists are revising upwards their forecast for the year as a whole. Consumer credit is growing rapidly, especially for mortgages, and consumer confidence and retail sales growth remain sky high.

There is, however a more fundamental point. It is unfortunate that nearly all the public discussion focuses on the rate of growth rather than the level of economic activity. A little while ago, I suggested that the US economy was so overheated that it needed a recession or extensive slowdown to regain a normal non-inflationary rate of activity (March 29, 2001). Some of these considerations may apply to the UK.

Tim Congdon, the economist, has examined why domestic demand and living standards have risen so much faster than output in the past five years. The combination has been possible because of the siphoning-off of domestic demand into imports and the improvement in the terms of trade, both associated with the rise of sterling (Lombard Street Research, June 2001).

My colleague Philip Stephens foresees the present overvaluation of sterling and high payments deficit ending in tears. He is worried that sooner or later sterling will fall with a jolt, inflation and interest rates rise and "quite possibly the economy will tip into recession" (FT, July 13).

One of the few well-established laws of economics is that what comes up usually comes down. So sterling probably will crash. But we have no idea when. We do know however, that for year after year the MPC and other august authorities have been predicting a fall that has still to materialise.

Morals from recent history are difficult to extract. The first episode of an over-strong pound occurred in 1977-78 when Denis Healey, the then Labour chancellor, achieved a domestic stabilisation of sorts, under the cover of an International Monetary Fund programme. The recovery in sterling soon became too much of a good thing. The Treasury wanted to curb it to prevent British goods becoming uncompetitive, while the Bank of England wanted to "unplug" sterling for fear of the monetary consequences of currency intervention. Lord Healey came down on the side of the Bank.

There was another phase, after Margaret Thatcher's election in 1979 when the new government at first ignored business complaints against the renewed rise in sterling, again for fear of the monetary consequences of intervention or lowering interest rates. Sterling did start to fall quite rapidly after the restrictive Budget of 1981, although not necessarily because of it. Economic recovery began at about that time but from such a depressed level that the greater part of the 1980s was written off in the popular mind as "the Thatcher recession".

The next episode of an over-strong pound was actually stopped midstream in the late 1980s. For by then monetary targets had given way to the doctrine of a stable exchange rate as an anchor for an anti- inflationary policy. This became encapsulated in membership of the Exchange Rate Mechanism during a period when British interest rates were geared more to the needs of German unification than those of the domestic economy. Sterling's forced departure from the mechanism in September 1992 was not followed by the kickback in inflation which, along with others, I had feared. This was probably because it took place during a bad recession.

If there is any lesson, it is that neither using sterling as an anchor nor ignoring it works as a policy; but the best time for a depreciation is after pressure on domestic resources has been reduced.

Meanwhile, the government's target measure of inflation, RPIX, has surprised forecasters by its recent rise, despite being massaged downwards by the chancellor's excise duty decisions in the Budget. The Goldman Sachs core rate of inflation, which eliminates temporary distortions, has risen to 2¾-3 per cent.

Goldman Sachs argues that this will soon go into reverse. But there are many problematical elements, ranging from the oil price to the assumption that UK wages remain in check. Even Harold Macmillan, the former prime minister, hardly a stern deflationist, used to warn about the danger of the UK being "an island of inflation in a world of deflation".

He may have done so in order to rationalise his own reluctance to overrule the Treasury and "go for growth". But whatever the motivation, the warning remains valid.