Hamish McRae: Is the Bank of England right to be nervous?

Inflation over the past year is back down to 2 per cent, exactly in the middle of the target range, with core inflation even lower. The economy may be slowing but low inflation makes the prospect of a cut in interest rates - should the economy need it - perfectly viable. The great concern of last year, the booming housing market, has been tamed without provoking a crash.

In as far as the aim of monetary policy is to guide the economy to steady low inflationary growth you would imagine that Mervyn King, governor of the Bank of England, would be delighted with the state of affairs. Were he a politician he would be congratulating himself. But he's not and he isn't. In fact he is worried about a strange conundrum in international finance. Why are long-term interest rates, after allowing for inflation, much lower than normal?

This might seem abstruse but actually it affects all our lives. Indeed we are all experiencing one effect in terms of different rates of inflation for different sorts of items. The price of goods in the shops is stable or falling but the price of assets, including houses, has until recently been shooting up, not just Britain.

The governor made a speech on Monday noting this mismatch between the price of current goods and services and the price of assets. In particular he suggested that eventually either current inflation would have to go up or the price of assets would have to fall.

There were, he said, two possible reasons for the mismatch. Either it was the result of Asian countries saving too much and buying assets in the rest of the world, particularly the US, thereby pushing up the prices of property and of bonds. Or it was the result of the very low short-term interest rates that Western central banks had run in the past few years, encouraging people to borrow to buy up property and other assets.

All this sounds a bit theoretical. But remember that we can see the practical effects all around us. Foreigners are busy buying UK assets - expensive flats, works of art, companies, even football teams. Britons are causing similar tensions in France and Spain when they buy up holiday homes there.

There are losers. These already include some pensioners. Low long-term interest rates mean pension funds are paying out lower than expected pensions: you need a bigger pot to get the same return. Losers may in the future include property-owners, if one of Mr King's possible outcomes proves correct. And if his other possible outcome, higher inflation, proves right, there will be other losers: people on fixed incomes and pensioners without indexed pensions.

If all this sounds as though economics is justifying its branding as the dismal science, there are at least two points of comfort. One is that central bankers are paid to worry on our behalf. It is their job to fret about anything that might destabilise the world economy, be it a big bank going bust, a surge in inflation, a collapse of a currency, whatever. So as long as Mr King and his fellows are doing the worrying for us, we can sleep easier o'nights.

A second source of cheer is that the world economy is growing well and that it is in no one's interest to stop this. Every year more and more people in China and India are being lifted out of poverty by the economic booms in those countries. If the world's main monetary authorities co-operate the chances of there being a gradual adjustment, rather than a catastrophic one, are all the greater. If there is growth everything is easier to cope with; it is when there is little or no growth that problems become harder to solve.

You can see that here in Britain. All right, maybe house prices are too high. Let's say, for the sake of argument, that they are over-valued relative to salaries by 20 per cent. If money incomes rise by 4 per cent a year and prices are flat, the imbalance could be pretty much eliminated in the life of a parliament. Good growth and incomes might rise by a bit more, clearing things even faster. If on the other hand, incomes rose by only 1-2 per cent a year, then the overvaluation would last a decade or more.

The problem for all of us is that we have no living memory of a world where prices consistently fall. You can see that in current inflation. We have gone in the past quarter century from a world of double-digit inflation to one of zero inflation in goods and 3-4 per cent inflation in services. But I think deep down we still think of a world where asset prices will tend to rise - and that notwithstanding the collapse of share prices in 2000-03 or indeed the falls in UK house prices in the early 1990s.

The world we seem to be moving towards is in two respects more like the latter half of the 19th century than anything in our lifetimes.

One was that it was the last long period of price stability that the world has known - the inter-war period was scarred by the Depression and the immediate post-Second World War period was distorted by the efforts at reconstruction. Inflation and interest rates in the first four years of the 20th century were similar to those during the first four years of this one - that is world-wide, not just in the UK. But our attitudes have yet to catch up. So unlike wise Edwardians we borrow, rather than save - though I have to say that saving money did not do the Edwardians much good in the end, for those savings were largely destroyed in the First World War.

The other similarity is that the years just before the First World War saw a burst of globalisation which has some parallels with today. Britain invested huge amounts abroad, some in the empire, some elsewhere. So we planted tea in India but also funded the railways in Argentina. More than half the country's savings in some years were invested abroad. Other European countries funded Russian development, for Russia was then, as now, the fastest-growing large European economy. Now the flows are somewhat different. It is Asian savers that are funding US consumption, rather than Europeans funding overseas investment. But the world is similarly interdependent.

This has two practical consequences for us here in the UK. One is that our affairs will in some measure be determined by decisions taken in China, Russia and of course the US rather than ones taken by the Bank of England. There is one particular new unknown this month: Alan Greenspan will be succeeded as the head of the US Federal Reserve by Bob Bernanke.

The other is that we do need as individuals to be careful. I think that was the core of the governor's message: there are huge uncertainties and therefore people should try in their daily lives to make themselves as financially bullet-proof as possible. Or put more simply: pay off those credit cards asap.