Six weeks ago, the Bank of England surprised no-one when it upped the rate of interest. Now, the question on economists’, borrowers’ and lenders’ lips (so that’s just about everyone) should be; what next?

Was the hike to 5 percent a temporary rise? One that is likely to be followed by sharp falls in 2007, or are we moving into an era when the rate of interest’s natural level is set to be higher? In recent weeks we have noticed a sharp change. Whereas, not so long ago, many believed rates would fall back next year, with Capital Economics, for example, predicting a return to 3.5 percent in 2007, now the thinking seems to be that inflation has to be nipped in the bud. And that central banks must raise rates, perhaps more than once, and keep them there until inflation is well and truly slain – and that, goes the argument, could take several years.

back in November, two quite different, and normally quite dovish, groups threw their pennies worth into the equation. The Royal Institute of Chartered Surveyors, a group that normally sees its members’ interests best served by having rates low, and the doves of the economic world – Capital Economics, seem to fly the nest, and become swooping hawks, urging the central banks to take a tough line.

RICS thinks we need to move fast, or otherwise things will get more serious. Its chief economist Milan Khatri said: “The recovery of the economy this year has exceeded all expectations, the stock market is at its highest level for over 5 years and there has yet to be any noticeable negative impact from the August interest rate rise on the economy or the housing market…The experience of late 2003 and 2004 shows that it takes several rounds of interest rate rises to take the heat out of the housing market when the economy is performing well”.

And Capital Economics applied economic theory to the problem as it warned: “Higher rates and weaker growth may bring little or no immediate reduction in inflation. Central banks need to be prepared to sit it out. Interest rates may need to be kept high for an extended period.”

Capital Economic’s esteemed top man, Roger Bootle, has been thinking about the Philips Curve. This is the idea, commonly accepted as truth before the stagflation of 1970s, that there was a trade off between inflation and unemployment. That to keep unemployment down, we need to tolerate a little inflation.

The theory was apparently blown apart, during that nasty period of economic history, the ’70s, when the world got both. Inflation went up and up, while unemployment rose too. That was known as stagflation.

Some explained the dismal performance of that era by saying it was because of factors beyond our control – such as the rising price of oil, that inflation rose, and that prices went up regardless of what the job market was doing. While from the world of academia, Edmund Phelps, who recently won a Nobel prize for his work, said that actually the relationship was not between inflation and unemployment at all, rather it was between inflation expectations and unemployment.

But the ’90s changed all that thinking. We had low inflation and low unemployment. It was a golden era, when the world’s top economies could have their cake and eat it at the same time.

Mr Bootle reckons he knows why. Globalisation, he says, made the Philips Curve flat. Thanks to trade, the world could grow, demand could soar, the jobs market could thrive, and yet inflation could stay in check.

But that’s all very well, argues Mr Bootle. But if we can have low unemployment without inflation setting in, equally we can have rising inflation, and rising unemployment. The two factors seem independent of each other.

In fact, continues the argument, what determines inflation is expectations, and our experience in the recent past. A one off shock leading to price rises, could reverberate around the economic system, leading to higher inflation expectations. Mr Bootle put it this way: “The result is that across a range of unemployment rates, the current inflation rate is determined, not by the current state of the economy, but rather by the inflation rate inherited from the past, plus the influence of current shocks and the change in inflation expectations. Those expectations will be heavily influenced by recent inflation experience, including the reaction to shocks.”

Mr Bootle is a clever man, and no doubt his argument contains a lot of truth in it. Nevertheless, we think he has underestimated the importance of technology and the Internet. Technology has made labour more productive and the Internet has broken the inflation habit. Retailers can no longer rely on our grudging acceptance of price rises, the net gives us too much information to allow for that.

The laws of economics are used to explain what’s happening around us. And every now and again, an older, formally discredited law, such as the Philips Curve gets dragged out of the economic cupboard. But surely, another law is just as important: Moore’s Law. The remarkable change in technology promoted extraordinary gains in communication and has facilitated globalisation, and has also enabled the emergence of the Internet, which exerts a constraint on inflation.

Until Moore’s law is allowed for within economic theory, any model that seeks to explain what is going on, is flawed.

© Investment & Business News 2013