Hamish McRae: The days of low interest rates are over

Something strange has happened in the past few days. The markets think the next move in interest rates will be up not down.

Most of us have been working on the assumption that if the economy headed sharply down, that would lead to a cut in inflation and would give the Bank of England the opportunity to reduce rates. After all, part of the Bank's traditional remit is to maintain stability in the economy as well as its specific task of keeping inflation close to 2 per cent.

You could not go as far as saying that were the housing market to tank, the Bank would rescue it with interest rate cuts, but that would be one element that it would have to take into account in framing policy. The surge in negative equity reported yesterday flashes a red light. For it has become pretty clear that the fall in house prices will be on a similar scale to that of the early 1990s, conceivably worse, and though the economy as a whole is in better shape now than then, there is no doubt that the hit on house prices will depress consumption for some time – years not months. Since consumption accounts for two thirds of total demand in the economy, that suggests economic growth as a whole will be very slow, certainly far slower than the Treasury forecasts.

So are the markets saying that the Bank will take a tough line on inflation irrespective of the performance of the economy and irrespective of the fact that our inflation almost entirely results from rising import costs rather than inflation generated at home?

If so it would not be hard to envisage the political dynamics. Suddenly Gordon Brown's great idea of an independent Bank of England would not seem such a great idea after all. In recent months there has been a lot of political sniping at the Bank by the Treasury: Alistair Darling is particularly hostile in private.

Last night the Governor of the Bank, Mervyn King, reminded the British Bankers' Association that we're not through this at all.

"After a decade or more of economic stability," he declared sombrely, "we are now facing a period of rising inflation and falling economic growth."

The one area that the Government has not up to now dared to touch is the independence of monetary policy, for that was the cornerstone of Gordon Brown's chancellorship. But Brown's own position is not secure. In the past few days I have heard a couple of people say that the Bank's role was something the Government should look at.

Parliament could, I suppose, vote through a change in the Bank's remit, making the maintenance of growth an explicit objective. I can't quite see that happening because it would, for Labour, be to hit the self-destruct button, but the weaker the Government becomes the less it might feel it had to lose.

In any case, it wouldn't work. Monetary authorities do have the freedom to set short-term interest rates but they have to work within the context of the credible. Alan Greenspan, the former chairman of the Federal Reserve Board, was able to drive down US interest rates from 2001 onwards without apparently generating much inflation or leading to a collapse of the dollar. But he had huge credibility built up over two decades. As it turned out that reputation was misplaced, for his cheap money policy helped lead to a global house price bubble and a sharp fall in the dollar. The consequences of both we have to live with now.

His successor, Ben Bernanke, started to make a similar error, pushing rates down in response to the US banking crisis, but now seems to recognise that the next move in US rates will have to be up. And at the European Central Bank, Jean-Claude Trichet has given a signal that euro interest rates will rise as early as next month.

This affects us here because major central banks have to move in a certain harmony. There is room for them to take into account individual circumstances – indeed they have to – but if the other major central banks are increasing rates in response to higher inflation, the Bank would have to have a good reason not to do so. Were it to try and hold down rates, the danger would be that sterling would weaken and long-term interest rates would rise. Actually both have already happened to some extent.

What is happening now is a realisation that this inflation is much more serious than was previously appreciated. This is a global phenomenon provoked by lots of small bits of evidence that if central banks were not careful the world could be back to the sort of inflationary spiral it hit in the 1970s. Our own shocker came on Monday when it was revealed that producer output prices rose over the past year by nearly 9 per cent. That is the worst since the present index started in 1983, and does not bode well for retail prices. We are not yet back to the 1970s but we appear to be heading in that direction.

Fortunately we are not going to get there, or at least I don't think we are, for three main reasons. The first is that policy-makers can remember the huge costs of allowing double-digit inflation to take hold. The social unrest here in Britain led to what was really a revolution. In the US there was a decade of tight money from the Federal Reserve, leading to a surge in unemployment. In much of continental Europe there were nearly two decades of double-digit unemployment. In Japan there was 15 years of stagnation. So the policy-makers will act earlier, if necessary putting up interest rates.

Second, inflation is not so embedded in the world economy as it was already becoming in the early 1970s, and in the developed world at least governments are not trying to conceal it by subsidies and artificial controls. It is quite hard to remember now that there used to be a pay policy in Britain whereby people could only get an extra £6 a week.

Third, the world economy is much more flexible and efficient now than then. China, India and Russia are functioning market economies, not command economies that seek to distort the price mechanism. In the West our companies are far more global and vastly more efficient in production and management of services. Small example: more than two thirds of the revenues of the FTSE 100 companies comes from outside the United Kingdom.

The important thing to remember is that the downturns of the 1970s and 1980s were by far the worst of the entire period since the Second World War. They were the only downturns when global GDP per head actually fell. Different countries have had different experiences in each cycle: for example, the UK had a rougher time than most in the early 1990s but came through the 2000s dip pretty much unscathed. But while the global outlook has undoubtedly darkened in the past couple of weeks – as the markets recognise by pondering whether interest rates may have to rise – there is nothing yet to suggest that this downturn will be particularly serious by comparison with past ones.