Inflation: The secret cost of living

So the dragon of inflation has not been slain after all and we are facing higher interest rates to try to corral it. The main British inflation measure, the Consumer Price Index (CPI), is up 3 per cent year-on-year. That may not sound a lot but it is the highest it has been since we switched from the old way of judging inflation.

The old Retail Price Index (RPI) was dropped so that we could harmonise with other European countries. But that index, the familiar one, is still used for setting pensions and index-linked government securities and is cited in most wage negotiations. It is now 4.4 per cent up on the year, the highest since 1991, and is expected to go above 5 per cent this spring.

What is the difference between the two? Mainly that the old measure includes housing costs, whereas the new one does not. Getting a roof over our heads ranks at the top of most of our priorities, so this does seem a bit rum - but there it is.

In a way, it does not matter whether inflation is officially 3 per cent or 4.4 per cent. The real point is that both these figures are high by the standards of the developed world. The CPI is higher than the European average and the RPI higher than the US.

For many of us, the actual rate of inflation we face is higher still. As our graphic shows, the various components of the CPI have gone up at different rates, but beyond these are other costs that many people have to bear. These include university fees; the charge for council services; the London congestion charge; and energy costs.

By contrast, some things have actually fallen in price, including clothing and shoes and a lot of electronic equipment, including computers.

As a crude rule, over the past few years, the things we have to pay for, such as council tax and petrol, have gone up faster than overall inflation; and the things we choose to buy, such as a flat-screen TV or a jumper, have risen more slowly or even gone down.

It is easy to explain this differential inflation. Things we can import have tended to stay the same price or go down. That is thanks to a combination of rising international competition and technical advance. The growing role in world trade of lower-waged economies such as China, India and, to a lesser extent, Eastern Europe has the effect of squeezing the price of most tradable goods and services.

The main things that have not come down much are energy prices (although they are now a bit lower again than they were) - partly because of the growing demand for energy in China.

By contrast, the things we cannot import or whose technology is moving only slowly, have become much more expensive. We can buy a TV set made in China but we cannot get the municipality of Shanghai to collect London's rubbish - though I understand some of our rubbish is indeed being shipped abroad.

What is harder to explain, and in some ways more troubling, is the rise in the price of things that are not in the CPI, most notably housing. Britain has had inflation before and it has had house booms before, but by any standards the present one is remarkable. As a rule of thumb, average house prices have been three to four times average earnings. Now they are over five times, pushing six. This is a global phenomenon, with just about every country bar Germany and Japan seeing huge rises. But we have a particularly bad dose of it.

Bad? Well, for people who own houses already that may seem fine. But for the young, for people in lower-paid jobs and for people who don't have parents who can help them on to the housing ladder, high house prices are a disaster. Socially, an excessive housing boom is destructive in that it discriminates against the young and the poor and in favour of the old and the rich.

There is a further issue. Many people borrow against the security of their homes to spend on other things: the so-called "equity take out" in the sense that they are taking out for their current needs some of the value, or equity, they have in their home. In recent years, about 5 per cent of our current spending has been financed by this form of borrowing. As a result, we carry a huge burden of debt, more than most Europeans and about the same, relative to income, as Americans, who have for generations been the world's biggest personal borrowers.

As we all know, we don't just borrow on mortgages; we also borrow on credit cards. In fact, we are really good at that. Britons have more credit card debt than the whole of the rest of Europe put together.

Unsurprisingly, the Bank of England is worried. It is worried about its formal duty to keep inflation within one point either side of the target of 2 per cent. So the 3 per cent was just OK: the bank did not have to write a letter to the Chancellor explaining what has gone wrong and what it would do about it.

But it is also worried about its wider remit, which predates these inflation targets and which is to maintain general stability in the economy. There is no explicit requirement; it is just what all central banks are responsible for. High house prices are a potential source of instability because they may fall sharply and people may lose their homes. We saw that in the early 1990s.

So the Bank of England is pushing up interest rates. The lags between movements in rates and the various forms of inflation are uncertain. We know there is some sort of link through house prices. We also know that higher rates will slow the economy more generally, but just how quickly this happens is unclear. And while the interest rate may be a crude weapon, it is the only one the Bank has got.

The practical question now is whether the 5.25 per cent rate is enough to curb inflation. The general perception in the financial markets is that there will be another increase in the spring. People should be prepared for 5.5 per cent, maybe more.

Will that lead to a housing crash? Not necessarily. It could happen, but perhaps more probably prices could plateau for several years, maybe falling a bit but not collapsing. Gradually, incomes would catch up and houses would become more affordable again.

What is clearer is that people who carry high credit card debt should figure out how to get that under control. As a country, we are already starting to do that. Household savings have been rising now for some time. But, naturally, there are many people who have a big struggle to save, and that will continue to be an individual and a national problem.

So will the present bout of inflation roar on? The answer must be no, because the authorities cannot allow it to do so. It will rise, at least on the old RPI measure, for a few more months, but by the end of the year it should be falling again. One thing is sure: if it does not come down pretty fast, expect still higher interest rates until it does.