Cheap money era is ending

THE interest rate response to fears of a return of inflation will top the global economic agenda this week.

Here in the United States the Federal Reserve will announce a decision today amid expectations that it will signal an end to the low interest rate era - even if it holds off on a rise until its next gathering in June.

In Britain the unrelenting rise in house prices makes a hike in Bank of England base rates - which have risen twice since November to 4% - all but inevitable later this week. This is despite the fact that the new consumer prices index, now targeted by the Bank, shows inflation to be benign.

But it is price rises two years down the road, not now, which are the focus of the Bank's attention. Several members of its interest rate setting Monetary Policy Committee have indicated that it may be necessary to lift rates now and calm the consumer and housing boom pre-emptively. Even if this means that Governor Mervyn King has to write to Gordon Brown to explain his reasons for being off target.

There is an irony in this. The missed target clause was added to the Bank of England Act to deal with the possibility of an overshoot because of financial shocks.

The only shock at present is that house prices have continued to rise despite the Bank's predictions that they would flatten.

It is possible, even likely, on current trends that in two years time the inflation profile could look very different. Here in the US it is already starting to look as if the fears of deflation - falling prices, earnings and asset values - which caused the Fed under Alan Greenspan to lower rates to 1%, may yet prove a false reading.

Work conducted by the Federal Reserve Bank of Atlanta, one of the banks which contributes to US decisions, suggests that bringing rates down to their lowest level in 50 years was a mistake.

The Atlanta Fed believes the headline inflation figures were distorted by an unusual pattern of residential rents and used car prices.

These rather mundane factors accounted for two-thirds of the reduction in America's prices index from 2.8% to 1.2% in the two years to December 2003.

Low interest rates led renters to buy homes on a large scale and crushed the demand for used cars, because new vehicles could be bought with unusually cheap finance.

Now there are the first stirrings of a belief that the best of low inflation is behind us.

This does not necessarily mean a return to the double-digit price rises of the late 20th century. There are nonetheless ominous signs that we may all have been taking the 'end of inflation' thesis too seriously.

Among the main reasons for falling global prices has been low-cost production in China and the Far East. With so much goods production from textiles to electronics switched to China - where labour costs are a fraction of those in the West - it was thought that this would provide constant downward pressure on prices in our High Streets.

But whereas labour costs in China can be relied upon to be much lower than anywhere else, the same cannot be said for the raw materials that go into the goods.

Beijing's insatiable demand for energy, to fuel its expanding factories, is among the reasons that the US oil price has skipped up to $38 a barrel. Prices for some steel products and other raw materials have doubled in a year as a result of Chinese demand.

Now there are signs that Beijing wants to buy increasing quantities of beef, wheat, vegetable oils and soya from America, boosting world food production. Soya bean prices alone have climbed 80% in a year; wheat is up 20%.

The cost of goods in US shopping baskets, from paper to girls' clothing, is on the rise. Far Eastern demand then is starting to impact on Western prices and costs.

Western governments' borrowing is also at high levels, with the US, Britain and several major European nations running big budget deficits. The combination of a public and private credit explosion is potent and needs to be cooled.

So all of us who have trusted in bricks and mortar should brace for higher mortgage costs ahead.