Hamish McRae: Money will be nearly free, but will we have the confidence to borrow it?

The world of monetary policy will change a lot in the next few months. Here in Britain, Mervyn King has just taken the chair of his first monetary committee meeting as governor and the committee itself has a clutch of new recruits. Equally important, maybe more so, will be the shift this autumn to the European measure of inflation, which not only gives a lower headline number than our retail price index but is in some ways a purer measure of current inflation.

In Europe there will be a new head of the European Central Bank as Jean-Claude Trichet takes over, with important implications for the presentation of policy, maybe the framing of policy too. And in the US, as we move into winter, there will be a debate about the future of Alan Greenspan, whose current term as chairman of the Federal Reserve Board ends next April.

But there is, I suggest, a bigger change than any of this: as we move towards the end of the year we, and indeed those policy-makers, will be confronting the turning point in the interest rate cycle. Instead of pondering whether the Bank will cut rates today or later in the year, likewise the ECB, we will be asking about the timing and steepness of the upward slope.

It might, in the face of the threat of global deflation, be a bit odd to start wondering about rate increases but I suspect by the end of the year it will be so, with the first modest rises coming through next spring. The challenge for the policy-makers will be to manage a muted, careful rise in rates that does not disturb still-fragile growth, rather than snuff the growth out.

But first the British story, where there is clear scope for lower rates. We are experiencing a peak in UK inflation as conventionally measured at present (first graph) but seeing a turn-down on the European measure (next one). Hey presto! Change the measure and inflation falls from nearly 3 per cent to 1.2 per cent - a gap exaggerated by the swings in UK house prices.

Goods prices (third graph) are still falling but not quite as fast as they were. However the impact of this is more than offset by the fall in service sector inflation (final graph). As GFC Economics, an independent consultancy firm, points out, there is a real possibility of inflation as measured on the European basis, falling below 1 per cent later this year. Conclusion? There is scope for further cuts in rates here either now or through the autumn. Indeed, there may need to be cuts if inflation is not to fall too far later this year.

If this is right, then expect the interest rate weapon to keep the UK economy moving through the winter. Remember: cuts in rates feed very quickly through into demand because of the large floating rate mortgage debt. The throttle can be opened and closed much more effectively than in other economies.

Look elsewhere and rather different considerations will dominate the autumn. In the eurozone, political leaders are having to accept that growth will be pushed to exceed 0.5 per cent this year. In Germany there may be no growth at all. So the pressure on M. Trichet for still further cuts in rates will be huge. Some forecasters are predicting ECB rates of 1 per cent though the winter.

US rates, too, will remain at their present historically low levels - and insofar as it matters, so too will Japanese rates. So we will go into the winter with almost all the developed world with central bank interest rates close to or below 1 per cent. Only the UK will have rates of more than 2 per cent, and that is not very high.

So this winter will see something that we have not experienced since the early 1950s: a world where money is virtually free.

OK, it is not free to you and me. After the banks and other financial institutions have taken their cut, we will have to pay another couple of percentage points. But for anyone under the age of 50, money will be as cheap or cheaper than it has been at any time of his or her life.

Makes you think, doesn't it? What are these central banks doing? How should we react? One would imagine that we ought to go out and borrow - or at the very least stop worrying about our present debts. But all the evidence is that savings are rising on both sides of the Atlantic. The more money that is being thrown at us the more we are thinking, um, maybe not too bright to borrow it.

There are, I suggest, at least four reasons for this. One is the obvious one that we are aware that rates will not stay low forever. The second is we, as individuals (or as managers of companies), are unsure about future economy prospects: we may lose our jobs or there may be fewer buyers for our products. Third, as noted above there is the matter of transaction charges: money is cheap for the banks but not so cheap for us.

And the fourth? This is the interesting one. It is that the world is coming to distrust the monetary and fiscal authorities.

Here in Britain we do rather trust the Bank of England, a huge tribute to the previous governor, Sir Eddie George. But trust in the fiscal management of Gordon Brown is much weaker than it was a year or so ago, as the Treasury's forecasts are no longer being met. So consumption is rising more slowly and people are starting to save more.

Meanwhile in the US, citizens may have in the past trusted both the Federal Reserve and successive US Administrations, but the way they are reacting now suggests that patience is wearing thin.

American consumers are also rebuilding savings, with the result that demand is slack and unemployment rising.

On the Continent, sadly, there seems to be a widespread lack of trust by consumers in both fiscal and monetary policy. So tax revenues are stable or falling, deficits are rising and consumption stagnant. It is as though people do not believe that the authorities have the ability to boost demand - and because they don't have any faith in their authorities they hold back their spending and make matters worse.

These are early signs of the Japanese disease, hence the joke question: "What is the difference between the Japanese and German economies?" Answer: "10 years."

Here in Britain we have the scope to cut rates a bit, particularly as inflationary pressures ease further. On the Continent they have the need to cut rates if they want any growth in Germany at all. In the US they have done all the rate cutting they can and just have to hope that the lower dollar pulls the economy along.

But in all these three regions there will be the nail-biting question through the winter: "If money is nearly free, will people have enough confidence to borrow it?"

Somehow the central banks have to persuade people that though they will eventually need to increase interest rates, they will do so carefully, gently and only in response to sustained evidence of rising demand. Managing the turn of the interest rate cycle is always a huge challenge. But this turning point will be the most difficult one for half a century.