Hamish McRae: Bank's anti-inflation efforts will come to nought if the Fed won't play ball

Could we be in the early stages of a revival of global inflation - and if so, what does that mean for us?

The Bank of England, unlike the US Federal Reserve and the European Central Bank, has started to lean against inflation and can be expected to raise rates further in the months ahead. But an anti-inflation stance in the UK won't protect us much if there is a global surge, and the higher interest rates we might need would of course carry costs to the economy.

The background to this concern is that the world economy has been given a huge monetary and fiscal boost over the past three years. The US has had virtually free money - negative short-term interest rates - and a switch from a budget surplus to a deficit of 5 per cent of GDP. Japan has also had virtually free money and is running an even larger fiscal deficit. Most of the eurozone has had cheap money, though the problem there is compounded by the different needs of countries with quite high inflation, such as Spain, and low inflation, in particular Germany. And of course the deficits of the big three economies there have also moved above 3 per cent.

Finally, here in the UK, while we have not had particularly cheap interest rates, we have had a big surge in borrowing, and like America, a shift from fiscal surplus to a sizeable deficit.

This boost from the developed world has been augmented by expansionary policies in the two biggest developing countries, China and India. As a result, China has been growing at around 8 per cent and India has recently put on a spurt, also reaching 8 per cent growth. This growth has already shown up in soaring demand for commodities, which have pushed up prices (graph, top left). Indeed both the oil price and commodity prices in general are close to the top of their historical range.

So there are general underlying conditions that you might expect, on past performance, to generate global inflation. So far, however, this has not really shown through in the price indices in the US, Europe or the UK, while Japan still has deflation. The US, UK and parts of Europe have had a property boom, but this rise in asset prices has not yet fed through into current prices.

Why is this? A couple of reasons: in the US there has been extreme price competition in traded goods as manufacturers outsource as much production as they can to lower-cost countries. China's emergence as a low-cost world manufacturer is holding down US goods inflation. Meanwhile India's more recent emergence as a low-cost service provider has helped hold down service industry inflation. Here in the UK similar forces have been at work, for there is hardly any inflation in the private sector. Virtually all our inflation has come from the public sector, where costs have been rising at about 8 per cent a year.

So why the worry? Well, there are early signs of strain in the US. Stewart Robertson of Lombard Street Associates, who put together these figures, argues that the surveys of the National Association of Purchasing Managers suggest producer prices will be rising at 5 per cent by the end of this year (graph, bottom left). There has in the past been quite a good relationship between NAPM surveys and future inflation.

That, you might say, is America, not Britain or Europe. With the weak dollar inflating raw material and energy prices, sooner or later the US is bound to experience more inflation. Surely we can to some extent insulate ourselves from these pressures by sheltering behind the strong pound?

The answer to that is, yes, but only to some extent. The picture of UK inflation is complicated by the switch of measures. The two measures, the old retail index and the new consumer one, are shown in the next graph (top right). As you can see, we have a wonderful record on the new measure, partly because it excludes a calculation of housing costs and council tax charges for local services. (Note that the Chancellor has switched measures just as soaring council taxes have become a hot political issue.)

At any rate the Bank of England Monetary Committee is sufficiently concerned about rising inflationary pressures to start increasing rates even though the consumer index is for the time being below the target level of 2 per cent. The final graph (bottom right) shows one possible reason for that concern. Whenever in the past there has been a house price boom it has been followed by a rise in general inflation.

These inflationary fears are only beginning to be taken on board by the financial markets. They have taken the view that the prevailing mood of the next few years will be one of price stability or something very close to that. I happen to think that is the right view on a perspective of 10 years or more. Indeed on a long view I suspect the dangers of deflation are greater than those of inflation. But on a two-year view things may be very different. It is perfectly possible to get an upward spike in inflation in the middle of a long-term downward trend.

That spike would be damaging because it would shake the confidence of the markets, in particular the bond markets, that inflation was a 20th century problem. Governments around the world have been able to finance their deficits at very low long-term interest rates because of that confidence. Pop it and all borrowers, not just governments, would suffer.

So what is going to happen? Well, I think there will indeed be some upward movement in global inflation through the second half of this year and that this will force central banks to increase interest rates. The earlier the banks move, the safer it will be for the world economy. The position of course varies between different regions. Here in the UK, expect short-term rates of 5 per cent by the end of the year. That would be sensible and would give a reasonable chance that we can be weaned off our borrowing boom in a gentle and non-destructive way.

In the US, they have left it too late. The Fed should have tightened earlier. It will now be difficult for it to do much before the November presidential election. Maybe there will be one modest rise in mid-summer, but rising rates will be an issue next year, not this one. That is of course disturbing, for it will allow whatever inflation there is already building to get a firmer hold.

In Europe it is very difficult to know what is for the best. Ideally slow-growing Germany ought to have lower interest rates and fast-growing Spain ought to have higher ones. But nominal interest rates have to be the same for the whole eurozone. Because Germany has the lowest inflation it is in the odd position of having the highest real interest rates, while Spain's high inflation means it has negative real rates. Whatever the ECB does has to be a compromise and actually be wrong for some part of its empire.

Given that it will err on the side of caution, it is less likely to cut rates in the next month or so, despite pressure from Germany to do so. And eventually, maybe towards the end of the year, it will start to increase them.

From a British perspective the best hope is that the Bank will remain ahead of the markets, both on the upward movement of rates and on their eventual decline. But we are really very dependent on the rest of the world. If the Fed or the ECB makes a mistake we suffer too, and I think the Fed in particular may have made a serious mistake in pushing the recovery too hard without thinking of the inflationary consequences of its actions.