Economic View: If banks could stop the bubbles forming, they wouldn't have to be so tough in bursting them

The inflation outlook is darkening and has been for several months, but only in the past week or so have the full implications begun to dawn on the financial markets – that the next move in global interest rates might be up and not down.

When I floated the possibility here last month, I could not quite believe it would happen. And I still think that will turn out to be right for the UK. But rates in continental Europe and the US will almost certainly go up (in Europe probably next month) and the money markets here are consistent with higher UK rates by Christmas. Meanwhile, two-year rates in Britain have risen by one percentage point over the past month, with the result that anyone seeking to get a two-year fix for their mortgage will be paying more now than they would have done at the start of the year, despite the reduction in the Bank of England rate.

What has changed? The outlook for inflation for a start. We had dreadful producer price numbers last week and will probably have dreadful consumer prices this week. It looks very much as though the figure will rise above the 3.0 per cent it was at last month.

At a G8 finance ministers meeting in Osaka this weekend, the Chancellor, Alistair Darling, indicated his concern about inflation, even before he received the actual numbers on Friday evening. He is in good company, for the UK's worries are pretty much standard throughout the world. US consumer prices are up 4.2 per cent in the year to May, while in the euro area prices are up 3.3 per cent. In the developing countries, the situation is worse still.

You can catch some feel for UK inflation dynamics in the two graphs, one of which shows what has been happening to food prices, the other to the perception of inflation. As you can see, people now think prices have risen 4.9 per cent over the past 12 months. That is the median response and I would guess it will be pretty close to the retail price index – 4.2 per cent last month – when it comes out on Tuesday. People are not stupid. They don't trust the official consumer price index because it does not square with their experience.

One particular experience is the price of food. As you can see in the chart below, the processed food element in the producer price index is running up more than 10 per cent year-on-year and that is likely to pull up the food element in the consumer price index. Add in the rise in the fuel price and Simon Ward at New Star (who put that chart together) reckons the CPI will be nudged above 3.1 per cent.

It is worth making the point yet again that the things rising fastest are the things we have to buy every week, such as food and fuel, rather than the items we might like to buy but could put off for a bit, such as clothes.

This experience is universal throughout the world. In the US, the price of petrol has doubled over the past year and there fuel is even more of a necessity than it is in Europe. And in India, food prices account for 60 per cent of the consumer price index, as against about 11 per cent here.

We knew all this was happening but we did not think central banks would act as strongly as they now look like doing. Ben Bernanke at the US Federal Reserve has indicated that the next movement in rates will be up; Jean-Claude Trichet at the European Central Bank has done the same. Because UK rates are currently higher than either, you could argue there will not be quite the same pressure to do so here. In any case, they don't need to rise if the markets are putting rates up, as has been the case.

That leads to a further issue. There are two things about money. One is the price, the interest rate. The other is its availability, the terms on which the banks are, or aren't, prepared to lend.

Banks have been so scarred by their errors that they will be very cautious about their lending criteria for at least two or three years, maybe much longer. In as much as they are eliminating silly practices, such as lending more than 100 per cent of the value of a home, this is welcome. But there is a danger that "safe" borrowers will be rejected along with the less creditworthy.

This tightening of standards does, though, lead to an opportunity. If the commercial banks are more cautious about making loans and availability accordingly goes down, the central banks should take this into account when determining interest rate policy. The more restric- tive the banks, the lower the rate needed to curb inflation.

Look at this another way. During the house price bubble, the central banks ought to have increased rates by more they did to offset excessive banking exuberance, or at least lean against it. Now they have lower rates – or at least not higher ones – to offset excessive banking caution.

Quite how you engineer this is another matter. But the principle that central banks should alter policy to try to shave off the tops of the booms and then fill in the bottom of the troughs is surely sensible. This was the subject of a speech by Sushil Wadhwani, a former member of the Monetary Policy Committee, in Munich last week. His basic thesis was that central banks should "lean against the wind" to try to stop bubbles forming, rather than let them happen and then mop up afterwards. Inflation targeting is not enough because asset bubbles have their effect beyond the one-to-three-year timescale of monetary policy at the moment. Such an approach won't eliminate asset bubbles, nor will it completely alleviate their costs should they happen. But it can smooth out the monetary cycle, and has to some extent worked in Sweden.

We will see. One thing is sure, though: there will be huge pressure to rethink both commercial banking regulation and the excessive reliance on inflation targeting as the main guide for central banks. And the higher inflation goes now, the greater the need to figure out a way of cutting the costs of curbing it.

Ireland says 'no' and shows Europe the way ahead

The Irish rejection of the new EU constitution has obvious political ramifications, but will it have economic significance? I think that short-term the effect will be small but long-term it may turn out to be beneficial not just for Ireland but for the EU economy as a whole.

The first idea to dump is that Ireland has bitten the hand that feeds it. Yes, EU subsidies have been large, reaching more than 6 per cent of GDP at one stage. But the money was not actually paid by the EU for it has no resources of its own. It was paid via the EU by the two main net contributors to its budget, Germany and the UK.

Further, these subsidies may have played a helpful role in funding Irish infrastructure investment but the Irish take-off had little to do with that. Instead, it was due to the combination of well-crafted tax policies and a well-educated workforce. Together, these attracted inward investment, mostly from the US.

That points to the future for Europe: what matters is global competitiveness, not subsidies. The rejection will not directly affect Ireland's place within the EU, for while at a bureaucratic level there will be hostility, at a political level it will be tinged with admiration. The important effect will be the signal it gives to the new member states and to the more globally oriented older members, such as the Nordic countries. The former do benefit from EU subsidies, though on a smaller scale than Ireland, but have also followed the Irish example in trimming company taxation to attract inward investment.

The Nordic countries have followed the Irish example of developing export markets, with great success. Sweden and Denmark have the further advantage of retaining control over their own interest rates – the loss of which many people in Ireland are now regretting given the reversal in the property market.

If the result is a more multi-layered Europe, with countries competing where this improves performance but co-operating where it does not, then that must be good news for the regional economy.

Ireland carries many messages for the other member states.