At the beginning of this year, economists and the financial markets seemed confident that Britain was set fair for a Golden Age of steady growth and subdued inflation, cushioned by a similarly benign outlook for the world economy and quiescent commodity prices. Higher interest rates seemed a long way off.
Not any more. Beginning with the Federal Reserve's decision to lift US rates in February - for the first time in five years - this confidence has all but evaporated. Prices of shares and government bonds have tumbled as the markets have switched their attention to the danger of resurgent inflation and the prospect of interest- rate rises to hold it in check.
The markets overdid the optimism late last year and are almost certainly overdoing the pessimism now. The short sterling futures contract ended last week predicting that base rates will have risen to 6 per cent by the end of the year, compared with their current 5.25 per cent. Very few City economists are this gloomy; the money market has been distorted, as mortgage lenders have borrowed heavily.
It is worth remembering, however, that past upturns in interest rates have been very rapid. The first rise in interest rates in 1988 came just three weeks after the final cut. Base rates were then raised 11 times in the following three months, from 7.5 to 13 per cent.
This experience is unlikely to be repeated in the near future as the economy is growing at a more subdued pace. But there is a growing consensus in the City that interest rates will rise before the year end.
This hardly seems believable when underlying inflation in Britain is at 2.4 per cent, its lowest for a generation and within the Government's 1 to 2.5 per cent target for early 1997. But the markets have seen that the Fed is prepared to raise rates in anticipation of future inflationary pressures, and they believe that European central banks may well do the same.
'The role of the central bank is to think - indeed worry - about inflation before ordinary people start talking about it,' Mervyn King, the Bank of England's chief economist, said last week.
The Bank has already hinted strongly that it does not believe the Government is on course to meet its long-term inflation target without raising rates. Of the 35 independent forecasting groups regularly polled by the Treasury, 29 expect inflation to be outside the long-term target range at the end of next year.
Independent forecasters are also sounding warnings. The National Institute for Economic and Social Research has urged that rates be raised by a full percentage point within the coming year. Kevin Gardiner, economist at Morgan Stanley, believes rates will have to rise to 7 per cent before the Bank of England has achieved the 'neutral' policy to which the Fed aspires - neither hitting the brake nor pressing on the accelerator.
One reason for the worries has been the unexpectedly rapid pick-up in average earnings growth, up to an annual rate of 4 per cent from 3 per cent late last year. The Bank fears that if people are not convinced that the authorities are serious about keeping inflation down, they will try to compensate by boosting their pay settlements. This in turn will boost companies' costs and put upward pressure on prices. If employees succeed in winning higher pay increases, these inflation worries become self-fulfilling.
Uncertainties over inflation and earnings are mirrored to a large degree by uncertainty about prospects for economic recovery. The Chancellor still seems more worried that tax increases will stall the upturn than that too-rapid growth will stoke inflation. The Bank, unsurprisingly, takes the opposite view. The Government protests that it is as committed as the Bank to low inflation, but there are plenty of people who would probably be quite happy to see inflation higher. Mortgage holders and debt-laden consumers and companies would all gain from inflation in the short run.
The evidence so far is that tax increases have had little effect, with retail sales outstripping expectations. But even analysts who have long had an upbeat view of growth must be nervous about the number of people who profess themselves converts to the same view on the basis of such flimsy evidence. A temporary slowdown in growth later in the year could well produce another dramatic shift in sentiment.
In the meantime commodity prices are the latest worry, with prices being pushed up sharply as the aggressive international 'hedge funds' pile in after departing from the bond markets.
The London Business School's International Economic Outlook argued last week that surges in commodity prices frequently provide unnecessary scares about inflation. But anecdotal evidence suggests some cause for concern: Channel Holdings, the burglar alarm maker, said last week that it might have to raise its prices because of the 40 per cent jump in copper prices in the past seven months.
The LBS argues that world inflation will remain low and stable through the 1990s. But it warns that policy-makers are walking a tightrope: an unexpectedly strong world recovery or an adverse shock could upset the calculations. The bad old days of the 1970s could yet come back to haunt us.
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