Hamish McRae: Let us hope a 7 per cent interest rate is a bridge too far

Some day we won't have to keep on about rising inflation and interest rates; but not for a while yet. There have been three major chunks of new information about the UK economy in the past couple of days: the inflation figures themselves; the labour market statistics; and the Bank of England's Inflation Report. Taken together there is little there that undermines the increasing concerns that interest rates may yet reach 6 per cent this cycle.

The thrust of the Inflation Report, together with the official comments on it, are reported on page 42. The general market reading of this is that it, on balance, reinforces the case for another move to 5.75 per cent later in the year. The thing that struck me was the wide bands on the fan charts for possible inflation outcomes, bearing in mind that the risks are universally seen as being on the high side. More about that in a moment.

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The inflation figures out the day before did show that the CPI had fallen back below the 3 per cent letter-writing level - for people who do not follow this too closely, the Governor has to write a letter of explanation to the Chancellor when inflation goes above (or below) a trigger level. However the Bank of England's previous targeted measure, retail prices less mortgage interest payments (RPIX), remains above its ceiling of 3.5 per cent. Indeed it went above it back in December, when it went to 3.8 per cent and it is still at 3.6 per cent. Letters are required every three months if inflation remains outside the target bands, so a second letter would have had to be written by now had the original measure of inflation remained in place.

One can get nerdy about this and point out that the old RPIX was a better measure than the present harmonised index that we had to adopt because that was the European standard one. The RPIX certainly gave an earlier warning of mounting inflationary pressures than the CPI, and since the CPI excludes most housing costs it is certainly an unsatisfactory index. You can see how the early warning mechanism would have worked better under the old measure than under the present one from the first two charts.

But I think it is important to remember that inflation targets and the letter-writing discipline are only a means to an end. That end is to help guide monetary policy so that a balance is struck between curbing inflation and encouraging sustainable long-term growth. Whether interest rates go up by the odd quarter percentage point a few months earlier or later has market implications of course. People make money by getting the timing of interest rate movements right, and they lose it by getting it wrong. But for the economy as a whole it does not matter much whether rates are 5.25 per cent or 5.5 per cent. What matters are things such as global energy and food prices; what is happening to Chinese export costs; and people's expectation of house prices. Within this big picture, whether rates are 4 per cent or 6 per cent is important - as is an awareness that there is a real possibility rates may end up above 6 per cent.

Indeed I have just seen the first economist's paper that suggests that the peak may be 7 per cent in the next 18 months to two years. It comes from Chris Watling at Longview Economics and his argument is that inflation in the UK has become more pervasive than at any time at least since the Bank got its independence.

Part of the problem is that goods inflation has been very low for most of the past decade: the fall in the global price of manufactured goods has offset the rise in the price of services. But now world goods prices have started to rise again for the first time since 1998 and while services inflation has fallen from its previous peak, it is still running at close to 5 per cent a year.

In the short-term, expect some easing back of inflation on all measures but the 18-month outlook remains a greater concern. Internationally the crucial element will be energy, food and manufactured good prices and there is nothing we can do about those bar maintaining the present strong exchange rate - which of course is not directly within our control anyway.

Domestically, the crucial element will be the interplay between productivity and wage costs. The labour market statistics out yesterday are mildly encouraging on wage costs: up 4.5 per cent year-on-year and down a touch on the previous month. Unemployment figures, one indicator of spare capacity, were neutral: up on one measure, down on the other.

On productivity the big picture is that the UK private sector has been closing the gap between its productivity and that of other major economics, but the public sector has been holding the whole economy back. You can see that in the next graph, taken from the Inflation Report, which shows how the productivity of the overall economy has been consistently lower than that of the private sector. That is an opportunity and it will be one that our next Prime Minister has to tackle. If the productivity performance of the public sector could be brought up to that of the private sector, our potential growth rate would be close to 0.25 per cent faster a year. That may not sound a lot but over time that is a huge difference in wealth generation.

And of course the greater the growth potential of the economy the less we need worry about capacity constraints.

The Bank pays a lot of attention to capacity and rightly so. It also however has recently been pondering whether it ought to be paying more attention to money supply. The final chart goes back to 1880, yup 1880, and shows the relationship between broad money and prices. (I love those very long-term graphs.) The two very roughly go together until the past few years, when prices have been held down. That may be the result of technical changes in monetary systems that we don't fully understand. Or it may be because globalisation has held down current inflation, though it has not held down asset inflation. I suspect it is more the latter.

If you plotted broad money against house prices there would, I suspect, be a close "fit".

That leads to the biggest question of all. What is the Bank - or indeed any central bank - more interested in keeping reasonably stable: the price of goods and services or the price of assets? I would say both.

Excessive swings in both types of inflation are tremendously destructive socially, and eventually in economic terms too. The Bank, like most other central banks, has been very successful at the former task and an utter failure at the latter.

Last autumn I warned of the possibility of 6 per cent rates. That fear is now commonplace. I am beginning to wonder about 7 per cent. Let's hope that really is a bridge too far.