Hamish McRae: What goes up must come down

The bad news is that inflation has shot up and until it starts to come down the Bank of England cannot cut interest rates. The good news is that when it does start falling it is likely to come down fast – and accordingly increase the scope for rate cuts.

No one will have been surprised that the consumer price index has risen in the past year by 4.4 per cent. For many of us even the rise in the retail price index by 5 per cent feels too low, when you consider the rises in the things we have to buy every week, such as food and fuel, rather than the things that we buy from time to time, such as clothes and electronic goods.

But while the figures are merely telling us what we already know, the increase in inflation to more than double the target of 2 per cent is a blow. It is a blow to Government finances, for come September public pensions and state benefits will be indexed upwards, pushing public spending way above budget expectations. It is unlikely there will be a corresponding increase in revenues. Result: yet higher borrowing.

Of course it is more of a blow to the rest of us. It reduces real living standards for a start, with people on fixed incomes particularly hard hit. The only effective weapon to control inflation, higher interest rates, is a blunt instrument. Given what is happening to the housing market, they can't go up and it would make sense to try and ease the pain by getting them down. But that can't happen. Result: paralysis.

We are not alone in this. On the Continent, Euro area inflation has been slightly higher than ours, resulting in an increase in interest rates there last month. Europe too needs a cut in rates, for it may even be that the German economy contracted in the second quarter of this year – we will get the figures tomorrow – but it can't have them for the same reason as us. The US, where inflation is higher still, does have lower interest rates – official rates of just 2 per cent – but these have failed to revive the housing market, where prices have fallen even further than in Britain. Look further to the developing world and inflation is even worse. In China it is over 6 per cent, while in India the latest figure I have seen is 11 per cent.

But none of this helps us. We are still in a jam even if other countries are in a similar position. What will help will be a fall in global energy and food prices. Here the news is more encouraging, particularly the oil price. Oil is crucial. Not only is it is the largest single primary source of energy – larger than gas or coal and far larger than nuclear or renewables – but it is also an important feedstock for chemicals. The oil price has been falling for some weeks and has continued to fall despite the hostilities in Georgia. Never say never, but it does look as though, for this economic cycle, the peak price has passed.

If that is right it is profoundly important. There are long lags between a change in the oil price and changes in the price of goods and services. Take food. Food prices have been driven up by the oil price, partly because of higher transport costs, partly because of more expensive fertiliser and other inputs, and partly because land that was being used for growing food has been shifted to growing biofuels.

It will take a year or more for the oil price to work through, so do not expect any early decline in food prices. But if you think about it, for inflation to come back down you don't need a fall in prices; all you need is for them to stop going up. That is what inflation is. If food and fuel do fall in price, that speeds up the process.

This decline will be reinforced as growth slows in the US, UK and Europe. The slower economies grow, the more their demand for raw materials falls. Prices will be further driven down if growth in China slows, and there have been small signs of that happening right now. Manufacturing production fell last month for the first time for at least a decade. Now that might seem unsurprising since a lot of factories have been shut to reduce air pollution, but there may be something deeper happening. Don't expect China to go into recession, but even slower growth would help take pressure off global energy and raw material demand.

That will affect us here. So it is quite plausible that a year from now the CPI will be not only be below the central point of 2 per cent but it could be down to 1 per cent. Things have changed fast on the upward part of the cycle and could change just as fast on the down. We will get the official line on this today in the Bank of England's Inflation Report. I expect it will not be encouraging but having been overoptimistic in recent reports, it may now overcompensate. As for policy, the Bank's monetary committee will want to see actual evidence of falling inflation before it can start trimming rates. The Bank is required to aim to bring inflation back to 2 per cent and it has to do what it has to do.

What does this mean for the rest of us? I think the best way to see this surge in inflation is as a one-off hit to our living standards. We are all learning to economise, perhaps by driving less, perhaps by fitting low-wattage light bulbs, maybe by bringing sandwiches to work ... whatever. For a couple of years, living standards will rise by less than they would otherwise have done and over the next few months might fall. But we knew that we would have to take some sort of hit as a result of the end of the housing boom.

People have been relying on borrowing against their homes to support consumption and that had to stop some time. Consumption is two-thirds of the economy, and as a result the prospects for growth for the back end of this year and through 2009 do look quite dark. There is no getting away from that. But a rapid decline in inflation from this troubling peak, coupled with the prospect of falling interest rates either later this year or early next, would reduce the pain. So watch the oil price and keep the fingers crossed.

h.mcrae@independent.co.uk