Inflation begins to bite back

THE case for cooling the Anglo-Saxon economies becomes stronger by the day. In the United States, growth was slightly weaker than expected in the first quarter but there was worrying evidence that inflation is on the march.

Here at home the latest Nationwide index, showing house prices rising at an 18.9% annual clip, will be enough to frighten even the most dovish member of the Monetary Policy Committee into the hawk's nest.

It now looks all but certain that the Bank of England will raise its key interest rate next week to 4.25% and the Federal Reserve, the US central bank, will not be far behind.

The big debate about house prices in Britain is now over whether it will be a hard or soft landing. The ratio of house prices to earnings currently stands at 5%, which is the highest level on record. Although relatively low interest rates still mean that households are not stretched.

But as the National Institute warns today, that can easily change. The Bank's gradualist approach to interest rates may encourage 'the mistaken belief among consumers that there is little risk of substantial increases'.

If property prices do start to ease down, as a result of higher rates, then the impact on the overall economy could be substantial.

If house price inflation were to be reduced to 4% then growth next year would ease to 2.8%. But were there to be a 20% fall then consumer spending would collapse by 2.5% over the next 12 months. That would be a case of from boom to bust.

The National Institute also reminds us that Chancellor Gordon Brown still has a serious budget problem. If the public finances remain on their present course, he will need to find £15bn through increased taxes or spending cuts if the government is not to ride roughshod over its own fiscal rules.

What is clear is that even if the new consumer prices index, rising at a modest 1.1%, registers no need for an interest rate increase, the Bank will need to act regardless. An inflation index which leaves out housing costs - a huge part of consumer outgoings - is a deficient tool.

The risks of pent-up inflation are starting to magnify. Shell and BP are glorifying in big profit increases because the oil price has climbed above $34 a barrel. But they are not alone. Commodity prices are increasing, the steel glut has come to a rapid halt and prices are rising. ICI shares have taken a knock because of fears about rising raw material costs.

Average earnings are rising and the great housing boom, and credit explosion which has accompanied it, will lead to a rising money supply.

The most potent measure of rising inflation risks is the American GDP measure (known as the deflator) which jumped a brisk 2% in the first quarter.

This may not be a return of the great inflation of the 1980s and 1990s but prices have a habit of rising and biting you when least expected.

Drugs drought

GLAXOSMITHKLINE and Astra Zeneca are two of Britain's small band of world-class companies. But there is little in the first-quarter results to make the pulses race.

To the contrary, the powerful competition from copycats, as staples like Paxil (Seroxat) go off patent, and the long journey of new molecules to market is making life a constant struggle for GSK shareholders in particular.

The overall lacklustre performance, whatever the reasons, provides a sharp reminder why so many investor groups have real concerns about chief executive Jean-Pierre Garnier's unchallenging performance targets.

Astra Zeneca has pinned a great deal of its ambitions on the anticholesterol compound Crestor for which it has a marketing budget of $1bn.

But so far progress is slow. The ambition is a 20% market share, but just 6.1% or $129m has been achieved in the first quarter.

At GSK, the story is very much one of sales slumps in the face of the generic challenge. Among the exceptions, giving a fillip to the share price, is the jump in sales of asthma drug Advair up 22%.

There are three promising drugs to be launched this year, a once-a-day Aids compound, a new combination diabetes tablet and a treatment for incontinence. So a pick-up should be seen by the fourth quarter. But none of these are blockbusters.

Investors will have to wait to 2005 for something exceptional with a breast cancer inhibitor seen among the best prospects.

Drug development is a long-term business so there is something of a mismatch between the sprint required for quarterly reporting, and the marathon necessary to bring new compounds to market.