Jeremy Warner's Outlook: Lesson of the 1970s is raise interest rates

The main news in the minutes published yesterday of the Monetary Policy Committee's last meeting was not that David Blanchflower had voted for a rate cut – he usually does – but that the committee gave serious consideration to imposing a pre-emptive rate rise. The idea was only rejected because the committee thought medium-term inflationary expectations were still relatively well anchored, and because an unexpected Bank base rate rise might be counterproductive by appearing to exaggerate the MPC's concerns about the inflationary outlook.

Nonetheless, the Bank's flirtation with the idea of a rate rise, even as the economy slows sharply, goes to the heart of the debate about how to deal with the present spike in inflation.

Mr Blanchflower thinks it doesn't matter, or at least that it is unlikely to lead to second-round inflationary effects because Britain's flexible labour markets mean workers no longer have the power to win inflation-busting pay awards. Others think differently, and worry about a return to the inflationary wage spiral of the 1970s.

As if to hammer home the point, tanker drivers have just won a double-digit pay award after strike action. This may encourage other unions into thinking they can again achieve results by going on strike. Rising inflation will also trigger a review of the three-year pay deals agreed by public sector unions.

The lessons of the 1970s hang over policymakers like a spectre. In last night's Mansion House speech, the Chancellor, Alistair Darling, warned that to return now to inflationary pay settlements would undermine rather than raise people's living standards, with a damaging circle of wage increases eroded by steadily rising prices.

The Chancellor is citing the sort of "cost push" analysis of inflation that was very much the fashion in the 1970s. For most businesses, labour is by far the biggest cost, so if its price is inflating this is bound to be felt in more generalised price inflation as businesses seek to pass on their increased wage bill.

Yet the reality is subtly different, especially when the economy is slowing rapidly as it is now. In such circumstances, businesses that agree inflation-busting wage deals may find it impossible to pass them on. This was the case even in the 1970s and is doubly so today. Harold Wilson once famously called inflation the mother and father of unemployment, and this indeed is the true danger in what's going on with prices.

What we've got to worry about is not so much the inflationary consequences of rising wages as their propensity to make British industry uncompetitive and therefore subject to repeated state bailouts or outright insolvency.

As the UK discovered in the 1960s and 1970s, there are limits on a country's ability to devalue its way out of trouble.

A sharp rise in oil prices was the other main ingredient to the toxic mix of rising inflation and unemployment we saw in the 1970s. Hence Gordon Brown's "mercy flight" to Jeddah this weekend to try and convince the Saudis to turn up further the taps of oil supply. In itself, it is unlikely to do the trick. The horse has already bolted on oil price.

Perhaps regrettably, the biggest lesson of the 1970s is that higher oil prices should not be fought with lower interest rates. Those countries, such as Germany, that resisted the temptation to counter the oil-price shock with lax monetary policy survived the decade much better, with relatively low overall inflation and unemployment.

Experience strongly suggests that the correct policy response to rising oil prices is to tighten interest rates, not loosen them, even though both higher oil prices and interest rates are deflationary in their consequences. In other words, short-term pain for long-term gain. Unfortunately for Labour, such medicine is not exactly conducive to its chances of re-election in two years time, but then that was the whole point of having an independent monetary policy – to free policy of political manipulation.