Hamish McRae: Stand by for higher interest rates

Prepare for higher interest rates and expect them to stay high for quite a while. The inflation figures are shocking and cannot be explained away by sharp increases in such things as food and furniture.

Formally, consumer prices are up only 3.1 per cent on last year, enough to trigger the Governor of the Bank of England writing a letter to the Chancellor about it. But, of course, that figure is wrong. The new Consumer Price Index was brought in to harmonise our method of calculating inflation with that of other EU countries - it used to be called the "harmonised" index. It has been consistently lower than the old Retail Price Index, largely because it does not include housing costs. For most Britons, housing costs are quite important.

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The RPI is up 4.8 per cent, the highest for a generation. That is the measure used by the Government itself to determine the interest it pays on its own index-linked securities, for its index-linked pensions, and for other index-linked contracts. It is also the measure used by pay negotiators. Even if you exclude mortgage interest payments from it, and I can see an argument for that, the so-called RPIX is up 3.9 per cent. That used to be the Bank of England's preferred measure - and it is the highest inflation rate of any major developed economy.

This raises two huge questions. What will happen to our interest rates, since higher rates are the only effective way of curbing inflation? And what does it say about our financial management more generally?

On the first, I don't think we should rule out the idea that interest rates will reach 6 per cent. I have felt that for some months and I am afraid that those fears have proved increasingly justified. Of course interest rates will go up next month; the only issue being by how much. But while it is possible that the present rise in prices is a surge that will reverse itself in the autumn - in which case, this coming May rise might prove to be the peak this cycle - there are risks that inflationary forces are becoming embedded in the economy.

The housing market is the best evidence of that, with most professional commentators expecting average price rises of about 6 per cent this year and next. While that may be lower than rises in recent years, it is higher than the rise in earnings and higher than present borrowing costs. That this should be regarded as normal and sustainable shows how unrealistic people have become.

So the question is what level of interest rates is necessary to change this inflation psychology? For what it is worth, the markets seem to be predicting a peak of 5.75 per cent but, in a way, how long rates stay high, or at least high-ish, will be more significant than the actual peak.

My instinct is that UK rates will remain the highest among the large developed countries for a couple of years, maybe more. That is one reason why the pound shot through the $2 mark yesterday: people think it will deliver a good return for some time to come. (The other reason was dollar weakness, for people think the US economy will slow, dollar rates will come down and the US will become a less attractive haven for foreign capital.)

What does this say about our financial management? Well, I don't think it would be fair to argue that the independent Bank of England has somehow failed. Sooner or later, inflation was bound to stray more than 1 per cent either side of the central rate of 2 per cent. But the letter from the Governor to the Chancellor seems a touch complacent: there are lessons to be learned.

Lesson one is that the shift to the European harmonised inflation measure was an error. The target rate was cut from 2.5 per cent to 2 per cent when the move was made because it was reckoned to understate inflation by that amount. Actually, the understatement varies but had we stayed with the old measure it would have signalled the dangers much more strongly last autumn. Had the Bank moved rates up more urgently, it might have pre-empted the latest horror.

Lesson two is that focussing on a single (and flawed) measure of inflation is simplistic. What matters are the general inflationary pressures in the economy and, beyond that, the threat to economic stability that inflationary psychology creates. It is not the fault of the Bank that it is supposed to focus on this narrow measure: that is what the Chancellor has required it to do. But going forward, we need to figure out some way of broadening the Bank's brief.

This needs to embrace the financial stability of the economy as a whole, taking into account the exchange rate, house prices and inflationary psychology. I don't know precisely how we do that; I just know we need to think about it or there will be more trouble ahead. For example, this move of the pound above $2 will help put downward pressure on prices. Thus, other things being equal, it cuts the oil price in sterling terms. But that level for sterling looks unsustainable in the long-term, so we need to be wary of the extent to which this really helps contain inflation.

This isn't a revolutionary suggestion: in the US, the Federal Reserve is required to take into account these wider issues, and does not in fact have an explicit inflationary target.

Lesson three is that monetary policy and fiscal policy have to work in harness. At the moment we have a continuing and unplanned boost to demand from fiscal policy, for the deficits for the past five years have been consistently larger than originally forecast by the Chancellor. The Bank, by contrast, has been running an increasingly restrictive policy, though maybe not restrictive enough.

So the two horses - fiscal and monetary - have been pulling in different directions. A lot of the blame for current inflationary pressure should go down to the Chancellor, not the Bank of England. Had he stuck close to his original borrowing plans, and not puffed up the economy with huge increases in public spending, we would not have had such a strong inflationary boom. In a sense, home-buyers will have to pay higher interest rates because they are competing with others, including the Government itself, for scarce savings.

So there are lessons to be learnt. This is not jumping-out-of-window time. Inflation may be the highest for a generation but it is not heading back to the double-digit levels of the 1970s and 1980s. But there is going to be a slog to squeeze inflation back to acceptable global levels and that slog will last more than a few months. There is no magic wand. And if this slog takes a little of the gloss off the record of the Chancellor, then I am afraid that is fair enough. He was happy enough to boast when UK inflation was lower than that of the other large economies. If you take the credit, you must also take at least some of the blame.

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