Hamish McRae: If house prices keep rising, so will inflation

Inflation is back, interest rates will go higher to push it down again - and it looks as though Gordon Brown will leave his present job with a higher rate of increase in the cost of living than the one he inherited 10 years ago.

We'll come to that in a moment. First, why is inflation rising and will it continue to do so?

The best starting point is to look at which prices are going up and which prices are not. Most people reckon inflation - their inflation - is much higher than the 3 per cent of the consumer price index (CPI), itself the highest since it was launched in 1997.

To most people it is a pretty odd to have an index of the cost of living that excludes accommodation. The old retail price index (RPI), which includes housing, is up 4.4 per cent, the highest since 1991. Even if you knock out housing from the RPI (the so-called RPIX), it is still 3.8 per cent.

For many people the actual inflation rate is higher still, though for some it will be lower. As a rule of thumb, things that you need to buy - such as heating, council services, mortgage payments - have gone up faster than the CPI, whereas things you choose to buy - clothes, shoes, TV sets, phone calls - have gone up slower, or even fallen in price.

Given this phenomenon, you can understand why there is such distrust in official inflation figures, hence its launch this week of a personal inflation calculator so you can work out your own rate of inflation.

The Office of National Statistics is desperate to demonstrate its independence from the government. Its press notice yesterday stressed that ONS statistics "are produced free from any political interference". It went out of its way to point out that the main culprit for the increase was the rise in fuel duty, brought in by the Chancellor on 6 December. And it ran counter to the answers given by the Prime Minister at his press conference yesterday.

You can argue about the detail, but what is beyond dispute is that British inflation is high by the standards of most of the developed world. The CPI inflation rate for the EU as a whole was 2.1 per cent in the year to November, when ours was 2.7 per cent, and the US inflation rate was 3.4 per cent, which (because it includes housing costs) compares with our November RPI at 3.9 per cent. Inflation in the two other G7 economies, Japan and Canada, is lower still.

So we have a problem. It is not a catastrophic problem, at least not yet. For a long time we have tended to have lower inflation than most of Europe or the US and by the autumn, assuming energy prices carry on down, our own rate should be falling again. But it is a problem in the sense that inflation will be a constraint on economic policy for the foreseeable future in a way that it has not been for a decade or more.

The financial markets expect that there will have to be another increase in interest rates, to 5.5 per cent, some time in the spring, and some economists think they may go higher still. I personally think a 6 per cent Bank of England interest rate is possible, though that is a minority view.

Whether rates do go much higher will depend largely on whether inflation becomes more embedded. Pensions, state benefits and the return on index-linked government securities are all tied to the RPI. Wage negotiators look at the RPI as the benchmark, on the grounds that it more accurately reflects the cost of living of working people than the CPI.

However inflation is a global issue rather than just a British one. Put at its simplest, the world has up to now been rescued from higher inflation by the growing role of China, and to a lesser extent India, in the world economy. If you take the things that have been becoming cheaper - the clothes, shoes and TV sets mentioned above - the price has been held down by Chinese labour.

I bought a toaster for a tenner the other day, made in China of course. Think about that: it is hardly more than the price of a couple of toasted sandwiches. It has to be assembled, boxed and shipped around the world - and the shop selling it has to make a profit. That does not leave much to pay the poor people who had to make it.

Technology pulls down some prices, and that is why phone calls are becoming cheaper, but the strongest downward pressure comes from low wages in the developing world.

Now look at the things going up in price. There is energy and that is a global price, driven mostly by demand from the global economy, including China. (We are also paying somewhat higher electricity prices as a result of the drive for more sustainable energy - that comes at a price too.) But as for the rest, things like council services, higher education fees and higher housing costs, that is all self-generated. We cannot buy our council services from China.

The question is to what extent can we rely on globalisation and technology to continue squeezing down our inflation and to what extent we are going to crush out the inflation that we ourselves have been generating. As far as housing costs are concerned I am afraid we have a long slog ahead.

The Bank of England does not formally take house prices into consideration when setting interest rates. As explained above they are not in the CPI and keeping the CPI within one percentage point of the 2 per cent central level is what it is legally required to do. But in practice house prices matter enormously. They affect consumption, because people borrow against the value of their homes to spend on other things. And they affect wages because employers have to bid up for people in expensive areas.

They also affect society, with high prices helping the relatively rich who own homes and clobbering the poor who don't. They help the old against the young. And because they encourage people to take financial risks, they affect the stability of the whole economy.

So while the trigger for that rise in interest rates last week was yesterday's inflation figures, the underlying climate for higher rates has been set by the housing boom. Now it may well be that in a year's time interest rates will be coming down again. The headline inflation numbers should come down a little too. But until housing costs are contained inflation will continue to be a grinding concern.

And the role of Gordon Brown in all this? Well, he has puffed up the economy with a huge increase in public spending and a huge and unplanned increase in public borrowing. That has indirectly added to inflationary pressures. True this is a global problem and not just a British one, but had inflation remained low he would certainly have taken the credit. Since it has not he should take some, though not all, of the blame.