Stephen King: Globalisation is forcing the Bank of England to adopt a new approach to interest rates

"Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens." So claimed John Maynard Keynes inThe Economic Consequences of the Peace, published in 1919.

Of course, Lenin had a vested interest in bringing the capitalist system down, so a bit of debauchery was, in his eyes, a jolly good thing (although whether Lenin really ever said these famous words is still a matter of historical conjecture). Eventually, of course, Lenin and Keynes were proved absolutely right. Demands from the Allies for reparations after the Treaty of Versailles led in Germany to hyperinflation, the destruction of the Weimar Republic and the rise of the Nazis.

Fortunately, the UK doesn't have hyperinflation. Nor is Lenin in charge (although Andrew Turnbull, a former Cabinet Secretary, would argue that a latter-day Stalin soon will be). And there's little evidence to suggest the Government is in the process of confiscating, "secretly and unobserved", people's savings (other than through the 1997 pension "raid"). Nevertheless, and rather unexpectedly, there appears to be "a continuing process of inflation". Last week's inflation release prompted Mervyn King, the Governor of the Bank of England, to write a public letter to the Chancellor of the Exchequer explaining why there'd been a little bit too much monetary debauchery going on.

The latest inflation figures - for March - are worryingly high. Consumer price inflation is now running at 3.1 per cent, more than 1 percentage point above the Bank's 2 per cent objective, thereby triggering the Governor's letter. But this is "new-money" inflation. In "old-money" terms, using the traditional retail price data, inflation is higher still. Excluding mortgage interest payments (the so-called RPI-X measure), inflation is now 3.9 per cent (and has been running more than 1 percentage point above the Bank's old 2.5 per cent objective since December). Headline RPI, which includes mortgage interest payments, is now a whopping 4.8 per cent.

Admittedly, part of the rise in inflation relates to external factors beyond the Bank's control. Food prices have been on the rise globally, reflecting poor weather conditions, and last year's increases in electricity and gas prices - a lagged response to earlier increases in oil prices - will soon drop out of the year-on-year comparison, thereby automatically lowering the inflation rate. The story, though, doesn't end there. As Mr King made clear in his letter, "those factors account for only around one half of the pick-up in CPI inflation in the last year".

The Bank is increasingly concerned about the return of old-fashioned company pricing power. After a couple of years in which companies had to endure declines in profit margins as a result of higher fuel prices, it appears they're now fighting back. Margins can be rebuilt in one of three ways - cutting costs, boosting productivity or raising prices. More and more companies appear to be choosing the last of these options.

At first sight, the return of corporate pricing power is odd. Workers have seen their real, inflation-adjusted, wages continuously squeezed over the past 12 months, suggesting household spending should be on the wane. If so, companies might struggle to make price increases stick. The Bank, though, is worried that people are spending even if they're not earning. As Mr King put it in his letter, "spending in the UK economy, associated with continued rapid growth of money and credit, has recovered from the slowdown in 2005, leading to five consecutive quarters of robust growth". In other words, relatively loose monetary conditions may have paved the way for extra borrowing and, hence, extra spending, keeping the tills in the shops - and the "proceed-to-checkout" buttons on the internet - jingling and jangling.

All this should be enough to persuade the Bank of England to raise rates again in May. There is, though, a bit of a puzzle about the latest developments. It may be that the value of the pound is being debauched domestically through higher inflation but, on the foreign exchange markets, sterling is in fine fettle. The pound is now worth more than $2, bringing the cost of holidays in the US down to bargain basement levels. And, on the Bank of England's broad measure of sterling's performance against a basket of trading partners, the pound has been trading over the past few months at its highest value in years.

So, while sterling's "internal value" is under downward pressure as a result of higher inflation, its "external" value is remarkably high. Is there a connection?

The most obvious link is interest rates. Financial investors have not yet given up on their earlier belief in the Bank's anti-inflation credibility and are regarding the recent rise in inflation as being, mostly, a temporary aberration. However, to the extent that the lift to inflation requires higher short-term interest rates, investors will choose to buy sterling at the expense of other currencies which don't offer such enticing returns. As a result, sterling's value rises.

Beyond this, though, I think there's a threat to the Bank of England's ability to achieve price stability in a world of ever-increasing cross-border capital flows. The Bank is constantly having to "second-guess" what could be described as "the hidden forces of globalisation".

Shareholders of British companies sold to foreign investors often end up with more money: the shares are typically purchased at a premium to the market. London property owners who sell their houses to rich Russians end up with more money. Hedge fund managers who receive enormous inflows of cash from, say, Middle East reserve managers place bigger bets on the financial market roulette table, thereby leveraging their bonuses and ending up with more money. And, in all three cases, because the original funds come from abroad, demand for sterling goes up and the value of the pound rises on the foreign exchange markets.

These transactions can be described as external money creation. They weaken the link between UK interest rates and UK monetary conditions. The foreign firm contemplating a takeover of a British company cares little for the level of UK interest rates because it raises funds in international capital markets. The rich Russian depends on the oil price for the occasional foray into the London property market and, therefore, isn't fazed by the level of UK interest rates. The hedge fund manager also, indirectly, relies on the level of oil prices because higher oil prices ultimately imply higher foreign exchange reserve holdings in the Middle East.

Transactions along these lines suggest that old-fashioned techniques designed to determine the level of interest rates - the amount of spare capacity in the economy, the relationship between house prices and domestic incomes - are increasingly unreliable. Faced with these softening relationships, it's no great surprise that the Bank is putting more emphasis on money and credit. These do, after all, capture both monetary creation that is a consequence of the Bank of England's own actions and, in addition, the external money creation that comes from, for example, rich Russians. And given that money and credit growth is still so strong, it wouldn't be surprising for the Bank to hint that May won't mark the last upward move in UK interest rates. After all, unlike Lenin, the Bank has no appetite for debauchery.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com