Leading article: The dragon of inflation breathes fire again

The tale the Chancellor will have to tell in his Mansion House speech this evening will be far from the triumphal story that delighted City audiences in the years of plenty. Where Gordon Brown boasted of economic dynamism that combined high growth with low inflation, Alistair Darling has to confront an immediate future where both indicators are moving the wrong way. How long is a year in fiscal politics?

We had a taste of the more apprehensive, more austere mood yesterday, when the Office for National Statistics announced that the Consumer Prices Index (CPI) rose by 3.3 per cent in May, and the Governor of the Bank of England warned that the rate of inflation could exceed 4 per cent this year. Even now, inflation is rising faster than at any time since the CPI was introduced 11 years ago. If you take the Retail Prices Index that preceded it – a gauge which, for many, remains more realistic than the CPI – the 4 per cent bar has already been passed.

Inflation in Britain is still running far behind what it was in the 1970s. It is also running behind the level of the eurozone, although the gap is narrowing. By whatever indicator, though, our economy looks in considerably worse health now than it did when Gordon Brown made his move into Number 10. And inflation, the dragon Labour set out to slay once and for all when it came to power, is threatening a destructive return.

That inflation is racing ahead will come as news to no one. We have all felt it in our pockets and seen it in our bills. For householders attempting to remortgage, for car-owners regularly filling up the tank, for anyone who buys food – and that is surely every one of us – prices have accelerated since the start of the year. The greater surprise for most people will probably be that the official figure of 3.3 per cent for May is not higher.

The concentration of price increases in energy, food and borrowing means that, for many, the real rate of inflation is indeed higher. Those areas where prices have fallen mostly relate to purchases of choice rather than necessity. This also means that inflation is affecting poorer people most. The next, entirely predictable, twist will be an upsurge in demands for pay rises to match inflation. Discontent in the public sector is rising; the tanker drivers have shown their muscle. And so the spiral will go on.

Controlling inflation was the central task entrusted to the newly independent Bank of England by the Blair/Brown team in 1997. But the letter the Bank's governor was obliged to write to the Chancellor made singularly depressing reading.

Far from offering remedies, Sir Mervyn King blamed "unanticipated" global price increases; suggested that things would get worse before they would get better, and stressed the general climate of uncertainty. Mr Darling, in response, stressed the need for restraint in public pay. Ministers are to set an example by forgoing their pay rise this year.

Sitting tight and exercising restraint do not feel like remedies for the pain people are already feeling, let alone the worse pain that probably lies ahead. But neither the Bank nor the Government has room for manoeuvre. The standard answer to inflation is to raise the cost of borrowing. But the credit crunch has already done that to potentially lethal effect in the housing market, and slowing growth is an argument for lowering, rather than raising, rates.

In the best case, says Sir Mervyn, energy prices will stabilise and there will be no more external shocks; the inflation surge will be temporary. Good fortune, though, has tended to elude the Brown Government. It would be reassuring to know that the Chancellor had something more solid behind him than the Bank of England's faith in better luck.