Hamish McRae: The inflation genie is out of the bottle

We should be aware that low interest rates may not last many more months

Inflation is on the march again – and has some way further to go before it comes back under control. Worse, if the Bank of England comes to be seen as soft on inflation, that could jeopardise the whole easy-money strategy that has helped to pull the economy out of recession. So the problem is not just inflation. It is the credibility of our willingness to do anything about it.

If that sounds alarmist consider this. The consumer price index, the one used as a target for monetary policy, is 3.5 per cent, against the central point in the target range of 2 per cent. That overshoot has led to the Governor writing to the Chancellor. But the CPI has grave flaws; most seriously it does not include housing costs, which most people would consider rather an important aspect of their cost of living. The retail price index, which does include housing and is the one most commonly used for setting benefits, pay deals and the interest in index-linked government debt, was up 3.7 per cent.

But that index also has flaws, most notably that it is affected by swings in mortgage interest rates, which are currently artificially low. The RPI excluding interest charges (the RPIX), which the Bank used to use as its main target for inflation, is up, wait for it, by 4.6 per cent. So the underlying rate of inflation, on what is generally accepted as the most representative measure, is actually a full percentage point higher than the official one.

So inflation is even worse than it appears. What happens next? Well the Governor's letter argues that inflation is likely to fall back to the 2 per cent level in the second half of the year and that the probability is it will then go below it. The Bank's Inflation Report, published last week, suggested that CPI inflation is likely to fall to about 1 per cent early next year – that is the mid-point of its expected range.

If that were to happen all would be well. Unfortunately there are a number of reasons to think it may be under-estimating inflationary pressures. A year ago the Bank thought that inflation by now would be close to 1 per cent. Indeed the very top end of its expected range for the CPI was 3 per cent. So it has been completely wrong. And it has been wrong despite the fact that the recession has been somewhat more severe than it expected then. We all make mistakes, but that was a big one.

Actually, the Bank has been consistently underestimating inflationary pressures for the past four years. I have been looking at some work by Simon Ward, the economist of the fund management group Henderson, and he points out that the CPI has gone up by 2.8 per cent a year over that period, not the 2 per cent target that the Bank was supposed to attain.

True we have had a huge monetary boost to the economy since then, with not just near-zero interest rates but the "quantitative easing" programme, which has pumped £200bn into the banking system. That was bound to generate some inflation and I think most of us would acknowledge that this was the right thing to do. The fact that the supply of mortgages has been strong enough to steady the housing market is the result of this and other measures to keep credit flowing. The monetary accelerator pedal has been flat on the floor and rightly so. At some stage, however, we have to get back to normality.

And that is the crucial point. We have to get back to a normal monetary position and we have to do so at a pace we determine, rather than one determined by forces outside our compass. The worst thing to happen would be to have to increase interest rates suddenly because of a loss of confidence in our ability to manage our own affairs.

The parallel is fiscal policy. The UK is not yet in the position of Greece, having its fiscal policy determined by outside forces, but we are in danger of that happening. The capital markets division of Royal Bank of Canada yesterday put out a ranking of sovereign risk – the risk that a country cannot repay its debts.

Ireland and Greece came at the top, as you might expect, followed by Portugal and ... yes, the UK. On that ranking we are more of a risk than Italy, France and Spain. That is just the view of one bank but it echoes those of others in the business of advising savers around the world of the risks of investing in different countries.

Now we all know the reasons for this and we all know that our fiscal position will have to be tackled after the election. There is an obvious danger that the next government will not have the authority to do so. I happen to think that it will, whatever the outcome of the election, but this issue will not be determined by commentators; it will be determined by global investors.

Given the fragility of our position on the fiscal side, it is all the more important that we retain credibility on the monetary side. The central thing investors will be frightened of will be any attempt by Britain to whittle away the real value of its borrowings by allowing inflation to nudge upwards.

Expect inflation to carry on rising over the next few months for several reasons. The stronger the recovery, the more demand there will be for energy and raw materials. For the past decade the world relied on cheap imports from China and elsewhere to hold down the price of traded goods and compensate for higher oil and other input prices. Now the emerging world is experiencing quite serious inflation and that will feed through into import prices.

As demand increases in the developed world, as mercifully is now happening, our own producers will be better able to pass on increases in costs. And here in the UK there will be further increases in prices as taxes (most probably including a rise in VAT) come through after the election.

None of this means that the Bank of England should be so concerned about inflation as to increase interest rates right away. That would be silly. What it does mean is that the Bank's monetary committee needs to be aware that its reputation is on the line. It should not assume it has the trust of the markets. If it is right about this surge in inflation being temporary that will be fine. If it turns out it is wrong then it will have no option but to start on the path back to normal interest rates, rates that reward savers rather than subsidise borrowers. All of us need to be aware that these low interest rates may not last many more months.

h.mcrae@independent.co.uk