Hamish McRae: Here's why interest rates continue to rise

Tomorrow the Bank of England starts its next two-day meeting to decide interest rates. There is a chance which, after last month's surprise increase to 5.25 per cent, no one in the financial markets would dismiss, that the Bank committee may increase rates again. Even if it doesn't, the financial markets are predicting that there will be two more increases, bringing rates to 5.75 per cent later this year.

That may be a far cry from the double-digit interest rates of the early 1990s, but the prospect of higher rates does seem a little disturbing. It also comes at what, in political terms, is an interesting time: the end of Gordon Brown's period as Chancellor and presumably his elevation to Prime Minister. He still has one more budget to go, assuming that Tony Blair makes it through the next couple of months, but the pressure of rising interest rates does, in a way, highlight both the Chancellor's triumphs and his failures in the job.

For there are both good and bad reasons why rates need to be higher. The good ones are associated with a strong economy, one that keeps surprising by growing faster than its long-term trend. The bad ones are associated with inflation, which is now the highest it has been for 15 years.

The good stuff first. The economy seems to have put on a spurt towards the end of last year, with its largest single element, private-sector services, particularly strong. Business optimism in December was the highest for three years. The volume of new business has continued to rise, and many companies expect to take on more staff.

Viewed from abroad, the economy also seems strong, for inward investment last year was a record. Now it is true that much of that was foreigners buying British companies rather than building plants here, but presumably they would not be buying firms if they did not feel confident about the direction of the economy.

Of course there are also instances of factory closures and of job losses, and there are also regions that feel, with some justification, that they are not getting their full share of this increased prosperity. But you would expect that in any economy where the structure of activity is changing rapidly. But overall, employment is rising steadily (and not just in the public sector), confirming a pattern of real buoyancy.

Just why this should have happened is complicated, and I don't think we yet fully understand it. Part of the groundwork was the labour market reforms of the previous government, but I think the British service industry boom has deeper roots. These include an historic strength in communications and financial services, the growing importance of the English language in international trade, and globalisation itself.

The roots of this success were established before Gordon Brown took office, but he must be given credit for its continuance. It is a curious irony that the part of the country that has done best out his stewardship, basically the South-east of England, doesn't vote Labour, while many of the regions that have done worst do.

This buoyancy means the economy needs higher rates to restrain it - or at least is able to stand higher rates should they been needed to restrain inflation. And so to the bad stuff.

Well, the less-good stuff, because this isn't jumping out of windows time yet. We will get January figures next week, but the Bank team will have had a sniff of them by now. In December, inflation on the old retail price index was 4.4 per cent, and it is generally expected to go higher in the coming months. On the new consumer price index, which does not including housing costs, inflation is "only" 3 per cent, the ceiling of the range within which the Bank is supposed to hold inflation. Taken together, these would be quite worrying, partly because wage rates are set with reference to the RPI, but more because inflation is becoming generally embedded in the economy in a socially destructive way.

I know that under the legislation that gave the Bank independence it has to write a letter of explanation to the Chancellor if inflation is too high or too low. I know too that most people mistrust the official figures anyway. This is partly because of the exclusion of housing costs, but also because of the tendency for things you have to pay for - such as council services and heating - going up faster than things you choose to pay for, such as a new TV set.

But the thing that will, when the economic history of this period gets written, be seen as really alarming will be the effects of the property boom. That is a form of inflation, even if the figures don't pick it up. To be sure, this is a global phenomenon, for in the developed world only Germany and Japan seem immune. But the UK has a particularly bad dose and, as we all know, this sort of inflation of asset prices helps to redistribute wealth from the have-nots to the haves. As well as redistributing from poor to rich, it redistributes from young to old and it does so in an arbitrary way.

It also carries financial risks. Some people are already getting caught by the surge in debt associated with the surge in asset prices. That is, however, only the bit of the picture that we see here in day-to-day news. It matters because Britons are enthusiastic borrowers: we have as much credit card debt as the rest of Europe put together. But it also matters because the whole world economic system has been flooded with cheap loans that eventually will have to be repaid. There are global financial risks that only show up when things get tougher: when interest rates start to go up.

To say all this is not to hold either the Bank or the Treasury responsible for global economic forces. That would be absurd. But you do have to see our own credit bubble, and our own housing boom, in its global context. We have a Bank of England that needs to lean harder against inflation from now on, and maybe should have leaned harder in the past. We also have a Chancellor who has puffed up the economy with a surge in public spending without raising the tax revenue to pay for it. After years of strong growth we ought not to have a deficit of close to 3 per cent of GDP. Indeed, one of the reasons why we are getting tighter monetary policy is because we have had too loose fiscal policy. The one has to compensate for the other.

My own guess would be that the Bank can wait a little before the next rise in rates, but it knows the inflation prospects better than the rest of us. If it does increase rates again tomorrow, it is becoming worried - and if it is worried, so too should we. Let's hope for no change, even if we know this is only a pause on the path.