Those (younger) families who will benefit from lower interest rates reducing their cost of borrowing will determine how the economy recovers – depending upon how they choose to deal with the savings created by lower rates.

A recent article by Bill Mott, fund manager of the PSigma Income Fund neatly set out three options.

Imagine, he said, the hypothetical Smith family sitting at home in their three-bedroom house in Middle England. They had a 70 per cent mortgage on their home a year ago but house price collapses of the past year have eroded much of the cushion.

Unfortunately, their existing fixed rate deal recently came to an end. They received a letter from their lender, which politely suggested they look elsewhere for a new mortgage as the new rate they could offer the Smiths had increased dramatically.

If the Smiths were to accept this offer, they would be signing up to increased monthly mortgage payments that would further constrain their spending for each month with the additional burden already in place of higher fuel bills and food costs spiralling.

At this point, the Smiths have little choice so they choose to shop around for a new mortgage. Wherever they go, they are greeted with huge arrangement fees and generally higher rates than they had previously. Having finally established a new mortgage from somewhere, they sit down as a family and review their monthly finances.

Things have to change and “belt tightening” is the new family way. Out goes the midweek visit to the Chinese restaurant, out goes the visit to Waitrose to be replaced with new shopping at Aldi and Lidl.

The second family holiday is now doubtful and the kids are told to ease up on the mobile phone bills and they decide to renew their car in two years time rather than this year.

After recent interest rate cuts to historic lows the Smiths sit down again to review their finances and find that they are going to be £80 a month better off on their mortgage as a result. The key to the UK economy is encapsulated in what the Smiths do next. Which of the following scenarios best describes the Smiths likely behaviour?

Scenario 1: They breathe a sigh of relief and revert to their old habits, spending the full £80 a month and regard the last few months as uncomfortable, but now over. They go back to Waitrose and start living the life they led before.

Scenario 2: They have been troubled by the last year and decide to bring a degree of caution to their lives. They decide to spend £40 of the £80 and decide to go out for a Chinese meal every two weeks and reinstate their second holiday but decide on the UK cottage rather than Lanzarote. They put the extra £40 into a savings account and pay off their credit card bills on time.

Scenario 3: The Smiths are so scared by the fright they have had over the last few months that their collective view is ‘never again’. ‘We have learned our lesson’, they say. They put the entire £80 aside each month to pay off their credit card bills and to build up their savings.  It will be some years yet before they revert to their more carefree lifestyle.

In these three possible outcomes rests the future direction of the UK economy.  If you multiply the Smiths by millions of other families in the same position, the outcomes are as follows:

n?The economy revives quickly. Domestic cyclicals such as pub operators and property companies are rejuvenated and disaster has been averted. It’s a “quick fix” but Armageddon has been avoided. Long term imbalances still need to be tackled.

n?An anaemic recovery is under way. This avoids the worst of recession but growth is muted and weak but enough to keep the stock market above its lows. This is the preferred solution because it allows long term rebalancing to occur.

n?We have a Japan style deflation/slump. However much money the Government throw at the Smiths through tax cuts and interest rate cuts, the Smiths and others are on a “spenders strike” and the UK would suffer a massive recession.

Bill Mott made his mark as an Equity Income Fund Manager in the late 1980s and early 90s when he established the Credit Suisse Income Fund, earning himself the title “Mr Income”. 

In 2000-2003, Mott turned Credit Suisse Income into the top performing UK Equity Income fund. In early 2007, Mott formed PSigma Asset Management with two former colleagues from Credit Suisse.

Earlier this year, the scenario three “spenders strike” was the prevailing psychology. However, Mott is of the view that scenario two, avoiding the worst of the recession, is the more likely outcome and we are starting to see this translate into real life. This should mean that equities will begin to perform much better during 2009.

*Trevor Law is a director with Montpelier  (Europe)  Ltd, the independent financial advisers based at Barston near.Solihull. E mail: TIlaw@montpeliergroup