Hopes that the British economy was beginning to move into a better balance between consumer spending and manufacturing have been quashed by fresh indications that the old ‘two-speed’ version is back in place.

Economists are starting to fret that Japanese-style deflation and stagnation could pose a greater threat to growth than does inflation.

Manufacturing output slumped by 5.3% in June, the biggest monthly fall since the infamous 1979 winter of discontent, and sufficient to prompt a sharp downward revision to the official estimate of second-quarter GDP growth. The manufacturing purchasing managers’ index for July fell below 50, indicating a contraction, for the first time since January, and provided evidence that the June collapse was only partly due to people taking holidays during the Golden Jubilee celebrations and World Cup.

The timber industry was not exempt from the June plunge in output. Month-on-month declines range from 0.4% for kitchen furniture, to 13.2% for veneer sheets and plywood. At the annual rate, however, kitchen furniture production increased by 12.6%, other furniture was up 2.9%, and builders’ carpentry and joinery output rose 5.9%.

These figures reflect the continued strength of construction, and the housing market in particular. According to the July survey of construction purchasing managers, the index of overall industry activity remained positive for the 42nd consecutive month, although the rate of expansion was weaker than earlier in the year.

Shortages of some construction products and materials were partly to blame for a further rise in the index of average input costs, from 62.6 in June, to 65.1 in July. Suppliers’ delivery times also lengthened in July – at the fastest rate since December 2000 – but the rate of growth in purchasing activity was the weakest in the current upturn in buying which began in February 1999.

The survey also shows that housing activity continued to rise at the fastest rate of the three broad construction sectors monitored, which include commercial projects and civil engineering.

Meanwhile the Halifax confirmed the robustness of demand in the housing market, with a reported rise in house prices of 1.9% in July, to an annual rate of almost 21%.

The latest survey data indicates that despite the fall in equity values, British consumers remain reasonably confident. The July poll for the European Commission by Martin Hamblin GfK, reveals that although households are gloomier about the overall economic climate, they remain confident about their personal financial position, with expectations that it may actually improve. This points to continued spending.

Certainly the pace of retail sales growth slackened in May and June. But there are few signs that British consumers have finally closed their wallets. Although the CBI says that retail sales grew in July at the slowest rate for 18 months, firms selling household goods continued to perform well. Demand strengthened among furniture retailers, with 43% reporting annual volume improvements, compared with none in June, and 32% in May. The British Retail Consortium adds that many furniture stores took forward orders on big ticket items in July.

In the past, consumer spending booms have led to inflation, but this time global deflationary pressures have prevented this. Manufacturers of wood and wood products kept their factory gate prices unchanged between June and July, and the high street price of furniture fell by 0.4%. Underlying retail price inflation, which excludes mortgage interest payments, jumped back to 2% in July, from a record low of 1.5% in June.

Nonetheless some observers remain more fearful of deflation than of inflation, citing falling world commodity prices and declines of 1.6% and 0.9% in the goods component of the UK retail price index over the past two months. The concern is that falling prices can encourage consumers to defer spending in the hope of still lower prices to come, thereby stifling production, while increasing the debt burden of both consumers and companies in real terms.