If the optimists are right, bank base rates are likely to come down again soon. And both bonds and shares may recover recent losses and show respectable gains through the year. But if the pessimists are right, the recent sharp sell-off in the British (and other) bond markets will prove fully justified. And equities will find progress tough even if the results season continues to produce modestly pleasant surprises.
I have been more optimistic than the consensus about inflation for several years, and I see nothing in the present data to change that stance now. Indeed there is every chance, as Roger Bootle of Midland Montagu argues in a paper today, that inflation is about to fall sharply to levels that will take many people by surprise.
Some simple arithmetic is enough to make the point. The annual inflation rate - the rise in prices over the year to the latest month - depends on two numbers: the retail price index a year ago, and the latest figure. We know what happened last year: prices rose quite rapidly from month to month as the fall in the pound after our exit from the exchange rate mechanism pushed up import prices. Prices were up 0.7 per cent in February, 0.4 per cent in March, 0.9 per cent in April, and 0.4 per cent in May.
If the annual inflation rate is to stay stable at its January rate of 2.5 per cent, there must be similar rises in prices each month this year. But that now looks extremely unlikely. Retail prices in January were actually the same as last August, according to the official Retail Price Index. Taking the latest three months compared with the previous three, prices fell by 0.1 per cent.
But let us be conservative, and also make a large allowance for the likely April impact of the Budget measures (such as the VAT rise on fuel and so on). Let's suppose these measures push up prices by 0.75 per cent (the Treasury's assumption) and that the withdrawal of mortgage relief adds another 0.2 per cent. Then let's assume that prices rise each month by 0.2 per cent. If this is correct, the inflation rate will still sink to 1.9 per cent in May.
This is only too plausible. Price wars in retailing - white goods, brown goods, groceries and even hamburgers - are still rampant and it is likely that the official statisticians are failing to pick up some of the downward pressures that exist. For example, there has been a major switch from doorstep deliveries to supermarket purchases of milk at much lower prices.
Many retailers that had hoped last year to rebuild margins have had to relent. It is a tough old world of bargain hunters out there. Moreover, there is little if any remaining impact from the devaluation. Sterling fell 12.8 per cent (on its trade-weighted index) between September 1992 and February 1993, and has risen by 5.5 per cent since then.
These are, of course, short- term factors. The gilts market was particularly concerned last week when the Department of Employment announced the first acceleration in the growth of average earnings for many months: the rise over the year to January was estimated at 3.25 per cent, up 0.25 points. If earnings growth really is picking up, any short-term slowdown in inflation could prove to be short-lived.
However, there are several reasons not to be too worried. The earnings figures include payments for overtime and bonuses that are closely linked to rising production. They can pay for themselves in increased productivity and add little or nothing to labour costs per unit of output. Unit labour costs rose by 1.3 per cent over the year to January. Earnings growth could recover to 4 per cent and still be consistent with an inflation rate of 1.5 to 2 per cent.
Moreover, the underlying wage settlements - the deals that affect basic pay levels - have remained subdued despite the pick- up in jobs, fall in unemployment and growth in the economy. At 2.6 per cent in manufacturing in January, settlements reported to the Confederation of British Industry pay databank were up on the 2.2 per cent level in the thin month of September, but still down on the 2.8 per cent recorded a year ago.
True, wage bargainers will attempt to win some compensation for the sharp rise in taxation next month. But it seems likely that employers will resist, if necessary by cutting jobs and raising productivity. Contrary to the argument of the inflation pessimists, most businesses are in no position to pass on costs - despite the evidence from the CBI quarterly trends survey that the economy is running out of spare capacity. If production was really hitting capacity constraints, more businesses would be taking the opportunity to raise prices. Instead, factory gate prices are still slowing down: the annual rate of 3.3 per cent in February surprised the markets again.
The explanation of the CBI responses on capacity may be more banal: companies do not necessarily answer in a consistent manner over time, and they may also take account of spare manpower as well as machinery. Since companies laid off people more quickly during this recession, the CBI responses may simply be telling us that businesses have not hoarded labour. The same CBI survey that showed spare capacity as a little below its historic average also pointed to remarkably subdued cost and price pressures.
With luck, the very fact that the inflation rate is falling may also help to set a more moderate climate for wage bargaining. After all, past inflation is one of the most important influences on pay, and hence on the domestically generated inflation rate. Low inflation helps to breed low inflation, reinforcing itself in a virtuous circle.
Nor does the world outlook appear to be threatening, despite the worries in the US bond market.
Oil prices are near their all-time lows in real terms, and are not likely to recover sharply when there is still so much potential output to come on stream in Kuwait and elsewhere.
Other commodity prices are edging upwards, as is normal for this point in the cycle. But the rise is very modest by the standards of past upturns, and the long-run trend still appears to be against commodity-intensive production. Printed circuit boards undermine the demand for copper, and plastics substitute for tin. Overall, UK manufacturers' raw material and fuel costs fell by 3.6 per cent over the year to February.
Looking further out, the great unknown is economic policy. At present the authorities are, if anything, over-cautious. They have been slow to appreciate the improvement in inflationary psychology, or the depressive influences at work in the economy. The Chancellor also has an incentive to save the best of the recovery for the run-up to the next election.
But irresponsible policy-makers are likely to find themselves more circumscribed today than in the past. This trend is in part intellectual: the case for central bank independence to remove temptation from politicians has made real strides.
But the trend is based on more than ideas. In the new world of enormous international capital flows, finance ministers who are perceived to be taking inflationary risks with their economies can expect sudden retribution in their own bond markets. A sharp fall in bond prices raises the cost of financing the government's deficit. A fall in the currency can also pressurise the authorities into an interest rate increase.
The Government has so far only nodded to the force of these arguments by conceding some discretion over the timing of interest rate cuts to the Bank of England, and by giving it more control over the gilts market. That will help to keep the Treasury on track.
More important, both Eddie George, the Governor, and Rupert Pennant-Rea, his deputy, are strong characters. It is difficult to force a Chancellor to raise interest rates, but the Bank's top team is likely to be more successful than its predecessors.