Factors that pushed especially hard on inflation were airfares (between November and December this year they rose 41.8 per cent), fuels and lubricants (prices increased this year by 2.8 per cent, the largest rise for a November to December period since 1996), and food, (prices, overall, rose this year by 1.6 per cent, the largest ever rise between a November and December period.)

Of course another factor pushing up on inflation is VAT. VAT went up in January 2010, and went up again this January. In the year to December, CPIY (that’s inflation minus the effect of indirect taxes such as VAT) rose by 2.0 per cent, up from 1.6 per cent in November.

Many are now saying inflation is out of control, and interest rates must rise. We are not so sure, and many economists still agree.

Chris Williamson Director and Chief Economist at Markit said: “The data in fact do little to change the medium term picture, whereby the short-term factors that are currently driving up inflation should disappear, meaning inflation will fall next year. Most importantly, underlying domestic demand remains very weak with signs that economic growth slowed towards the end of last year and is expected to remain subdued in the first quarter. Falling real incomes, high unemployment and widespread job insecurity mean demand is likely to remain lacklustre for some time, and also suggests that higher prices will not feed through to substantially higher wages and salaries. Any rise in interest rates is therefore likely to have little impact on inflation itself.”

Yesterday, the ITEM club from Ernst and YoInflation is primarily being driven by temporary factors such as a rise in VAT, high commodity prices and past depreciation of the sterling. Stripping away these factors reveals that underlying price pressures remain low. Indeed CPIY (ie inflation excluding indirect taxes) was depressed at 1.6 per cent in November.

“We are of the view that the MPC should only respond with monetary tightening in the event that high inflation begins to become entrenched in people’s expectations reflected by unsustainable increases in wage settlements. However in the current context of a weak labour market with wage growth well below pre-recession levels, this seems unlikely. Therefore an increase in interest rates right now will be premature and is likely to dampen an already fragile economy.”

This morning, Jonathan Loynes, Chief European Economist at Capital Economcis said: “don’t forget that the headline rate reached 5.2% back in 2008, but was down to 1.1% just 12 months later. With fundamental drivers like spare capacity, wages growth and money growth all still pointing to considerably lower inflation in the medium-term, we continue to think that the MPC should – and probably will – hold its nerve and continue to provide the economy with the strong support it will need to withstand the coming fiscal tightening.”

However, while we still believe inflation will fall back later this year, and it is way too soon to up interest rates, we reckon inflation will become a problem in a few years time. The inevitable increase in the Chinese yuan and the rise in Chinese wages will mean a reversal of the conditions that led to low inflation in the noughties. The retirement of the baby boomers will also see baby boomers dip into savings to fund their retirement – this is also potentially inflationary. The era of low interest rates will be with us for a few more years, but by the midpoint of this decade we reckon that will change.

In the US, data out last week revealed that consumer prices there rose by no less than 0.5 per cent in December, pushing the annual inflation rate to a seven-month high. In the Eurozone, the CPI rate of inflation rose from 1.9 per cent to 2.2 per cent. That may not seem like much of a rise, but it takes the annual inflation rate to above target for the first time in quite a while.

Meanwhile, in the UK, producer prices surged. Input prices rose 3.4 per cent on the month before, and were up 12.5 per cent on a year ago.

And in both the UK and Europe, top men are getting worried.

A certain David Cameron – who is fairly top in the UK, said last week: “We don’t want to go back to having an inflation problem as we had in the past.” He went on to make the case for savers, saying how they are being hit by negative real interest rates.

Meanwhile, Jean Claude Trichet, top man at the European Central Bank is getting very hawkish, fretting over rising prices, and pondering over German demands to put the brakes on.

And yet, look at the picture from a different perspective

Sure, US headline inflation soared, but core inflation – that’s with food and energy taken out – rose by just 0.1 per cent in December. In the Eurozone, core inflation was just 1.1 per cent. In the UK, rising oil and the VAT increase are the main reasons why inflation is high as it is.

The ITEM Club from Ernst & Young said: “Despite the mounting pressure of losing face due to stubbornly high levels of inflation that have consistently been overshooting the Bank’s forecasts, we believe that the MPC’s decision to keep monetary policy unchanged is sound.

“Inflation is primarily being driven by temporary factors such as a rise in VAT, high commodity prices and past depreciation of the sterling. Stripping away these factors reveals that underlying price pressures remain low. Indeed CPIY (ie inflation excluding indirect taxes) was depressed at 1.6 per cent in November.

“We are of the view that the MPC should only respond with monetary tightening in the event that high inflation begins to become entrenched in people’s expectations reflected by unsustainable increases in wage settlements. However in the current context of a weak labour market with wage growth well below pre-recession levels, this seems unlikely. Therefore an increase in interest rates right now will be premature and is likely to dampen an already fragile economy.

“Despite being in a particularly unfortunate position, especially with two successive increases in VAT, the Bank should hold its nerve in what looks like a difficult year ahead.”

This weekend also saw the news that some hedge funds are betting on a collapse in the Chinese economic growth machine. These predictions may or may not be right, but if they are, we can assure you, oil will fall through the floor, dragging inflation down.

But the real point about inflation is this. Rising prices are making most people worse off. Rising prices, when wages are not going up, actually have the effect of reducing demand, and in the long run can be deflationary. If interest rates go up at a time when people are becoming worse off anyway, the effect will be quite disastrous.

Of course, the Bank England made the opposite error in the noughties, cutting interest rates when people were already better off thanks to low inflation – but that’s another story.

That leaves two comments. One argument made in favour of upping rates is that we are getting used to interest rates that are abnormally low. We have some sympathy with that view, and a modest increase in interest rates to 0.75 or 1 per cent probably won’t derail the recovery, but may fix people’s expectations.

The second point is that later this decade wages in China may well rise, and when this happens, we may see underlying inflation pressures grow. But this is a problem for a few years’ time; it is not a problem now.

First things first, the argument that QE is creating inflation is surely wrong. The main factors leading to higher prices are changes in VAT and food and energy costs. QE does not impact on any of these factors. In fact, the only way it could be argued that QE is mildly inflationary at the moment is via the effect it is having on the pound.

But in the longer term, a rising money supply will lead to inflation.
You just need to bear in mind that the broad money supply in the UK, or M4 as economists call it, which includes credit, is the version of the money supply that matters. And while QE is creating rises in narrower definitions of money, we are not seeing credit rise, and so M4 remains stuck in the slow lane.

In fact, according to Bank of England data out Tuesday, sterling M4 contracted by 0.8 per cent in November, and annual M4 contracted by 1.4 per cent in the month, from a 0.8 per cent contraction in October.

It is debatable whether QE is doing much good, and may be creating bubbles in some asset prices, but it seems clear that up to now, it is having little effect on the money supply. Or maybe it is. Maybe if it wasn’t for QE, M4 would have crashed out of sight by now. And if that had happened, we would probably still be deeply immersed in recession, or maybe have fallen into depression.

In the great inflation or deflation debate, an interesting new argument has come to the fore in recent days. At the risk of the author making himself seem to sound old, this piece will christen the argument as The Bananarama Theory, and it goes like this: it’s not what you’ve got, it’s what you do with it, and that’s what gets results.

We refer of course to the Bananarama theory of the money supply. And the theory says it’s not how much money there is in circulation, it’s how fast we spend it that matters.

Irving Fisher, a man who died some 35 years before the Bananarama hit, put it another way: MV= PT. Or the money supply, times velocity of circulation, equals the number of transactions times average prices. In other words, if the number of transactions rises, but the money supply or the speed with which we spend money stays still, we get deflation. If, on the other hand, transaction levels remain fixed, but either the money supply or velocity rises, we get inflation.

Transaction levels are more or less correlated with output. In other words, if spending rises faster than output we get inflation; if it’s the other way round, it’s deflation.

On several occasions this column has warned about the appalling growth in the broad money supply. Despite all this quantitative easing, in the US, broad money, or dollar M3, has contracted every month this year. In the UK we have seen modest growth, but nowhere near to the level economists seem to think is required to sustain the economy. It all boils down to lending. Broad money includes credit, so if the central banks create money, but the commercial banks don’t then go out and lend it, broad money does not rise.

But the lacklustre performance of broad money is not restricted to the UK and the US, it’s a global phenomenon too.

But suppose that while the broad money supply contracts, we go out and spend the money we have got that much faster. In other words, velocity of circulation rises, maybe at a sufficient pace to overcompensate for contraction in the money supply.

Velocity of circulation is measured by taking GDP, and dividing by the money supply. And since US GDP is growing, but the money supply is contracting, then by definition the velocity of money must be rising.

The big question, however, relates to why velocity is rising. Is it rising because the return on holding cash is so low that we are going out and spending it? Maybe velocity is rising because investors, and especially institutional investors, are ditching cash and moving into other assets. If this is the case, then, in theory, rising asset prices will mean we feel better off and spend. This will lead to faster growth, and as a result banks will feel more comfortable about lending, and then … well, at that point the genie might be out of the bottle, and central banks may need to hike rates fast and start reversing quantitative easing by selling bonds.

There is some evidence to suggest this is what is happening. Writing in the Telegraph, Simon Ward, chief economist at Henderson Global Investors, said: “Evidence of a ‘dash from cash’ includes record retail buying of mutual funds and a decline in institutional investors’ ‘liquidity ratio’ – the proportion of their portfolios held in money and short-term securities.

“Meanwhile, equities, bonds, housing, commercial property, commodities, art, antiques and fine wine have all appreciated, in some cases substantially, over the past year – strongly suggestive of surplus money rather than the Governor’s mooted shortage.”

The FT quoted Michael Saunders referring to “a run-down in cash held by pension schemes and life insurers.” He said: “Excluding these groups, broad money growth is about 3 per cent annually, roughly what it was when the UK last emerged from recession in the early 1990s.”

Well, it depends on how you define money supply. You could equally interpret Mr Saunders’ finding as suggesting velocity of circulation is growing.

This all begs the question, is this view right? Is inflation really being stoked up, not so much because QE is boosting the money supply, but because the combination of record low interest rates and QE is increasing the pace at which we spend it?

We are not convinced. The fact is, both Brits and Americans are saving more than they did during the boom. Thanks to the impending retirement of the baby boomers, they need to save a lot, lot more. The prognosis for house prices on both sides of the Atlantic is awful, meaning home owners will feel hard up over the next year or so, or maybe longer. In the UK, wage rises are lagging behind inflation, and many of us are worried about the public sector cuts. In the US, the latest data on US personal incomes indicated that personal incomes fell 0.1 per cent in September.

So while the rises in some asset prices may make us feel more confident and willing to spend, there are lots of factors pushing in the other direction.

But let’s wait and see. No doubt the nomenclature of “The Bananarama theory of the money supply” is not going to gain much traction, but one can be pretty sure we are set to hear a lot more about the velocity of money.

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Inflation is a stubborn so-and-so. The Bank of England keeps saying the medium-term outlook is for the rate of price increases to slow down sharply; in reality, they just don’t do that.

Once again the rate of inflation was more than a full percentage point over target. Inflation, measured by the CPI index, which the Bank of England is supposed to track these days, came in at 3.1 per cent in August, the same level as the previous month. You will recall, the Bank of England’s target for CPI inflation is 2 per cent, and yet the index has increased by more than 3 per cent every month this year. Even more worrying, the index rose by 0.5 per cent in just the one month, suggesting there are underlying pressures that may lead to a rise in the annual rate soon. Even core inflation, that’s with food, energy and tobacco taken out, was 2.8 per cent, up from 2.6 per cent the month before.

UK Inflation 2003 -2010

Inflation as measured by the retail price index was 4.7 per cent, just a smidgeon down on July’s 4.8 per cent rate.

The fact that inflation has disappointed yet again will add more grist to the inflation hawks’ mill. Some members of the Bank of England Monetary Policy, or at least one member, are getting serious cases of the jitters over inflation. Andrew Sentance is the bank’s new hawk. He has been arguing that there may be less spare capacity than we had previously thought, hence inflation’s refusal to fall.

Other hawks will draw further evidence from the latest data from the British Retail Consortium (BRC) on shop price inflation. Shop price inflation, according to the BRC, increased slightly from 1.5 to 1.7 per cent in August. Okay, any rise in the index is probably a bad thing, but it still remains at a modest level. A 1.7 per cent rate is nothing to write home about, and certainly does not justify more than a paragraph of editorial here.

But the BRC’s measure of food inflation is more worrisome. “Food inflation,” said the BRC, “increased to 3.8 per cent in August from 2.5 per cent in July, the highest since July 2009 when it was also 3.8 per cent.” Still, on the bright side, non-food inflation was a trifling 0.5 per cent.

So, with figures like that you can see why the hawks are so vociferous. You can see why savers and people who rely on interest payments for their income are so up in arms. The truth is, right now, many savers are losing money; the interest they can obtain on their deposits simply lags behind inflation. They say not only is this unfair, it is also dangerous. By having negative real interest rates, the central banks are effectively saying debt is good, saving is bad. Those who were irresponsible enough to get into debt are being bailed out by record low interest rates. In short, central banks have rewarded the reckless and punished the prudent – moral hazard or what?

It is just that there is another way of looking at it.

First, re-examine the ONS data on inflation. Sure, nearly all the indices are too high, but there is one exception, and it’s an important one. CPIY, that’s inflation after deducting indirect taxes, was just 1.4 per cent, the same as the month before. In other words, much of the recent price increases can be put down to returning VAT to 17.5 per cent at the beginning of this year. And of course this makes sense. When VAT was increased from 15 per cent to 17.5 per cent, presumably all products that carried VAT went up by a similar amount. And since we tend to focus on annual inflation data, this hike in VAT is still having an effect and will continue to do so for the remainder of this year.

That real interest rates are negative may be unfair, but is beside the point. A hike in rates when inflation is being caused by changes to VAT will have no effect whatsoever on these underlying factors.

The same argument applies to next year. VAT will be rising again, therefore inflation will remain higher than would otherwise have been the case. But a hike in rates will not change this.

Now re-examine the data from the BRC on food inflation. Sure it was up, but then can that be a surprise? There was this little thing called a drought in Russia. Food prices can go up and down with the weather, and just as the drought has led to hikes in prices, the recovery will see prices fall back. Such is the eternal story of economic cycles.

Cast the net wider still and at least there is good news on producer prices. Last year, producer prices soared. And then a few months later, up went inflation. Earlier this week the latest set of data on producers was out, and this time the trend was down. Input prices, that’s what producers are forking out, were down 0.5 per cent in August on the month before, and output prices were up a mere 0.1 per cent. Of course, it takes longer for the year-on-year figures to reflect the change, but annual input price inflation fell to 8.1 per cent in August from 12.9 per cent in April, and output price inflation was 4.7 per cent, the lowest level since February.

Input versus output prices year on year % change

But the data that really contradicts the hawks relates to average earnings.

Average earnings growth including bonuses increased in the year to July 2010, and stood at 1.5 per cent. Okay, this was up on the 1.1 per cent rate seen in June, but is nonetheless a trivial rate of growth.

Look closer and the story becomes even more significant. In the year to July pay growth (including bonuses) in the private sector stood at 1.2 per cent, compared with 2.7 per cent in the public sector.

Stop there, re-read. Average pay growth in the private sector including bonuses was just 1.2 per cent in the year to July. Those who rely on interest payments on their savings for their income might think it is unfair that they are losing money, but they are no different from the rest of us. Average workers in the private sector are seeing their salary increases lag behind inflation. In other words, they are getting worse off.

Now, we are going to let you into a secret, but promise us this in return: if you are a member of the TUC, don’t tell Brendan Barber. Wage inflation in the public sector is set to plummet. There, we have said it.

But we believe it is unlikely that the wave of strikes we are being promised will gain much public sympathy. Cuts in public services may be unpopular, and may not be an entirely good idea, but since private sector workers have been making lots of sacrifices, why shouldn’t their counterparts in the public sector do the same? At least, that’s the feeling out there. See: The catastrophe that may arise for austerity Britain http://www.investmentandbusinessnews.co.uk/uk-economy/the-catastrophe-that-may-arise-for-austerity-britain/

When determining the course of inflation in the longer term, wages matter. In the 1970s the price of oil and other commodities went up in price, but inflation only set in because workers responded by demanding pay increases, which were then in turn granted. The problem of the 1970s was that demand was too high relative to potential output.

Mr Sentance may fear that we have less spare capacity than is thought, but in this Internet age, we would have thought that, actually, the truth is probably the opposite. Modern technology has made the economy more adaptable, and has developed the potential to create new capacity quite rapidly.

Low interest rates may be unfair on savers, and this may be legitimate reason for increasing rates. But it all depends on whether you think interest rate policy should be reactive or active. Should rates be set to reflect inflation, or set to influence inflation? Right now, any hike in interest rates will have no effect on the factors pushing prices upwards, but could cause almighty problems down the line.

This morning the ONS revealed the shape of the UK’s July inflation picture. The CPI rate fell from 3.2 to 3.1 per cent. And once again, poor old Mervyn will have to get his pen and paper out and knock off another ‘Dear George’ letter. “The bank is required to maintain inflation within one percentage point of 2 per cent in the medium term,” the letter will probably say, and “short-term volatility is inevitable, and the bank must not allow itself to be distracted by this” – or at least he will say words to that effect. Dr King will then talk about the latest inflation report from the Bank of England, and will conclude by saying the recent rise in the price of wheat coupled with next year’s hike in VAT will keep inflation over target in the short term, but in the medium term it will fall back.

But the good doctor is under pressure. The retail price index for July fell to 4.8 per cent, from 5 per cent the month before, but this is still way too high. There is also a growing conviction that the government will ultimately inflate away its debt.

On the other hand, core inflation fell from 3.1 to 2.6 per cent.

Perhaps inflation minus the effect of indirect taxes, or CPIY, is more relevant. In the year to July, the CPIY inflation rate fell to 1.4 per cent, down from 1.6 per cent in June.

If we look beneath the surface, then the story becomes more interesting. Average wages including bonuses rose by just 1.3 per cent in the year to June, from 2.7 per cent the month before. As for cost pressures, manufacturers’ input prices fell 0.1 per cent in July. Meanwhile, the British Retail Consortium had shop prices falling 0.1 per cent in July, following a similar fall in June.

Looking beyond these shores, across Europe CPI inflation rose to 1.7 per cent in July, from 1.4 per cent the month before. The lowest annual rates were observed in Ireland (-1.2 per cent), Latvia (-0.7 per cent) and Slovakia (1.0 per cent), and the highest in Romania (7.1 per cent), Greece (5.5 per cent) and Hungary (3.6 per cent). Compared with June 2010, annual inflation rose in nineteen Member States, remained stable in one and fell in six.

In Germany, inflation was 1.2 per cent.

If we strip out food, energy and tobacco, then the Eurozone inflation rate was 1.3 per cent, and over the last month this measure of inflation actually saw a 0.5 per cent drop.

In the US, consumer prices rose by 0.3 per cent in July, with the annual rate coming in at 1.2 per cent. But strip out food and energy, then month on month prices rose by 0.1 per cent and year on year they rose by 0.9 per cent.

In China, CPI inflation rose to 3.3 per cent from 2.9 per cent the month before. In China, just like everywhere else, the main driver of inflation is rising food prices.

You need to bear in mind that central banks can do little about food inflation. Clever though the likes of Mervyn King and Ben Bernanke are, they cannot make the drought in Russia go away.

In the UK, just like in the US and Europe, but unlike China, there are no signs of wages rising. At the moment we are becoming worse off. That’s bad news if you look at this from a human’s point of view, but economists see this as good news because, firstly, it seems they probably are not human, and secondly, because low wage increases mean minimal long-term inflationary pressures.

Since the yield on bonds in the US, the UK and Germany just keeps falling, it appears markets, too, reckon there is very little medium-term risk of inflation.

But here are a couple of interesting developments which may point to rising inflation down the line.

First of all, the rate at which the US broad money supply is falling has slowed. Dollar M3 contracted at 4.2 per cent year on year in July. Any kind of contraction in the broad money supply points to deflation, but this was the lowest contraction rate since March. Maybe, just maybe, the Fed’s quantitative easing is beginning to work. Let’s see what next month tells us.

Finally, in the US, the spread between 30-year and ten-year bonds is at an all-time high, suggesting the markets reckon inflation will be modest in the medium term, but will rise over the longer term.

The were a few “no-nos” in the press conference this morning. One such “no-no” was talk of a double dip recession. “We don’t consider this,” he told the journalist from the Sun (you can just imagine the Sun headline – King says I am not bothered about recession). But actually, his point was a serious one. The Bank of England makes projections based on expected performance over four quarters. It does not predict what the economy will be like in, say, Q4 this year; rather, its forecasts look at a broader time frame.

But for all that, its message was a little downbeat: “The considerable stimulus from monetary policy, together with a further expansion in world demand and the past depreciation of sterling, should sustain the recovery,” went the report, “but the strength of growth is likely to be tempered by the continuing fiscal consolidation and the persistence of tight credit conditions.” Mervyn King said: “Looking ahead, the UK economy is facing a major rebalancing away from private and public consumption and towards net exports. Achieving that rebalancing, while confronting those headwinds, is likely to mean a choppy recovery.”

But it boils down to this: the bank has downgraded its forecast for growth in the short run. As for the medium term, it was talking about a slow but steady recovery. It said history tells us recoveries from financial crisis are usually very gradual, but this morning in the press conference Dr King said that thanks to the recent budget, some of the downside risks have been removed.

As you know, the bank does not do precise forecasts. Rather, it publishes fan charts showing the range of possible growth rates, and here is the one it revealed today:

On the subject of banks and their lending, he kind of criticised and stuck up for them, all at once. Businesses have been complaining about their treatment by banks, but banks have been insisting that they have been providing ample funding to business. Dr King suggested there is no doubt that bank lending to business is not what it used to be; that money terms are much tougher; and the spread between the rates that banks charge and official bank rates is high. But, he said, there are good reasons for this, namely that banks are still recovering from the crisis and are trying to repair their balance sheets, and in any case the spreads between rates on lending to banks over Bank of England rates are themselves unusually high. He said for larger companies, some of which have better credit ratings than the banks, it makes more sense to borrow directly from the markets.

He was also asked whether the bank should extend quantitative easing to lend directly to SMEs. Here he was unequivocal. It is not down to the bank to decide where the money it creates should go. It buys government bonds. If the government decides to use some of the money from these proceeds to lend to business, then that’s its decision. He said this was purely a political judgement.

But the real attention is on inflation.

The inflation report stated : “Inflation is likely to remain above the 2 per cent target for longer than judged likely in May, in large part reflecting the increase in the rate of VAT to 20 per cent in 2011.”

But then it expects to see inflation fall below target.

And in this morning’s press conference, Dr King continuously emphasised how recent price hikes are down to one-off factors. He said: “Over the past three years inflation has been volatile and above the target for much of the time. That does not mean that the MPC has taken its eye off the inflation ball, nor has gone soft on inflation. We have not. Rather, it is the consequence of a series of large price-level shocks. With a rebalancing of the economy to come, price-level shocks are likely to continue to affect measured inflation. Monetary policy can do little about short-run movements in inflation and must reflect a judgement about the balance of risks to inflation in the medium term. Short-run volatility is making that balancing act more difficult. But in whichever direction monetary policy moves over the next few months, it will reflect the MPC’s judgement about the actions necessary to meet the inflation target in the medium term.”

He talked about the effect of hikes in the price of oil, and the one-off effect resulting from the big falls in sterling during 2009. And he talked about the effect of the reversal of the VAT cut from 17.5 per cent to 15 per cent in 2009, and the effect of the impending hike in VAT to 20 per cent in 2011. To illustrate his point he waved two charts at the press:

This one demonstrating the assessed probability that inflation will be over target over the next three years.

And this one showing how energy costs have contributed to inflation.

Dr King was right when he said changes in interest rates would have no effect on the inflation that is being caused by these external shocks. Savers might bemoan the fact they are enjoying negative real interest rates, but as far as using interest rates to influence inflation is concerned, this is an irrelevance.

The key as far as Dr King is concerned appears to be spare capacity. For as long as there’s lots of slack in the economy, the internal inflation threat, which is influenced by interest rates, will be weak.

Recent data from the ONS revealed that average earnings rose by just 1.3 per cent in June 2010.  Hardly the stuff inflation is made of.

And despite record low interest rates, the savings ratio has shot up from minus 0.9 on the eve of the recession to 8.5 in Q3 of last year. With consumer confidence falling, according to the Nationwide, and with retailer spending rising at a mere 0.5 per cent in the year to July according to the BRC, internal inflationary pressures are practically non-existent.

Mind you, the critics are already lining up. The following statement arrived in our inbox seconds after the Bank of England press conference had finished.

Report from Chris Williamson, Chief Economist at Markit:

“The Bank of England has downgraded its forecast for economic growth compared to its central expectation in May, but still seems remarkably relaxed about economic growth prospects relative to the US Federal Reserve and Bank of Japan, who appear to be getting increasingly worried about the outlook. This is all the more surprising given the particular combination of headwinds now facing the UK. On the domestic front, surveys such as the PMI and Household Finance Index show that business and consumer confidence collapsed following the announcement of the austerity measures in the emergency Budget of 22 June. The timing of this drop in domestic confidence is unfortunate as it has occurred alongside a slowing in global economic growth, emanating most notably from the US and China, which will hit export sales. With the PMIs for July suggesting that GDP growth has already slowed sharply from the 1.1 per cent surge seen in Q2, perhaps down to around 0.5 per cent, the Bank’s forecasts for growth look optimistic.”

The hawks are swooping, and their squawks are likely to become even louder this week. These days the UK central bank’s forecasts for inflation are nearly always wrong. But this time around the bank is expected to forecast inflation staying above target for the next 18 months. It seems the hike in VAT makes this inevitable.

The inflation hawks also fear the UK is growing too fast – after ONS data revealed a 1.1 per cent expansion in the economy in Q2. The National Institute of Economic and Social Research recently estimated the UK expanded by 0.9 per cent in the three months to July on the previous three-month period.

Then there’s producer prices. Data on Friday revealed that ‘factory gate’ inflation, or output prices for all manufactured products, rose 5.0 per cent in July. Input price annual inflation rose 10.8 per cent in July, compared to a rise of 10.7 per cent in June.

Thanks to the drought in Russia, wheat is set to rise in price, which may then have a knock on effect on substitute goods such as rice. And when VAT rises, further hikes in inflation are inevitable.

On this occasion, that famous economist Corporal Jones may have the answer: “Don’t panic.” At least, don’t panic about the danger of the economy growing too fast and creating inflation.

Average wages, including bonuses, rose by just 2.7 per cent in May over the year before, from 4.1 per cent the month before. And while producer prices are up on an annual basis, month on month, input prices fell 1 per cent.

According to a report from the Chartered Institute of Personnel and Development and KPMG, job losses from the public sector over the next two years may well be greater than the jobs created in the private sector. Apparently the net employment index, which measures the difference between the proportion of employers that intend to increase total staffing levels and those that intend to decrease total staffing levels in the third quarter of 2010, is all over the place.

The headline index stands at plus 2, suggesting employment growth, but only just. But the net employment intentions balance for the private sector is coming in at +19, compared to the balance for the public sector at -35.
Alan Downey, Head of Public Sector, KPMG, says: “Managers in the public sector have woken up to the scale of the financial crisis that they face, and many are now contemplating redundancy programmes. Surprisingly, some are still intending to recruit, albeit at a reduced pace. In the months ahead we will see a substantial reduction in public sector headcount as the cuts begin to bite. That is the painful but inevitable consequence of the coalition government’s determination to tackle the UK’s massive structural deficit.”

But before we look at the question of inflating away debt, first, how bad is US government debt likely to be? How is your hair? Make sure it’s held on tight, because the projections for US fiscal debt are enough to make it stand on end.

When George ‘Dubya’ Bush was president he introduced a temporary tax cut. It now seems his successor will extend it. As result, says Capital Economics, there is little chance of the fiscal deficit falling below 5 per cent of GDP this decade. Consequently, the federal debt burden is set to pass 100 per cent of GDP before the decade is out. But, and this is where you need to prepare your hairs, throw into the mix the Medicare and social security costs that will result from the ageing population, then by 2036 the debt burden could pass 200 per cent of GDP, and 350 per cent by 2050.

No wonder there are some who say the US is set to follow Japan into decades of lost growth.

The solution is easy: inflation.

Apparently this is what happened in the late 1940s.

But there is a snag. The only way the US could inflate its way out of trouble would be if the markets were fooled. Capital Economics says that “roughly $1,500bn of its debt, mostly Treasury bills, is due to mature this year, while another $1000bn is scheduled to mature in 2011. The bulk of those short-term bills are actually due to mature within the next 90 days. The average maturity for the outstanding stock of Federal debt is currently about four years, which is less than half the nine-year average back in 1947, when the debt to GDP ratio briefly exceeded 100 per cent.”

One assumes the markets would suss out any attempt by the Fed to get inflation up, so would demand higher returns when they are asked to refinance debt. Besides, much of US debt is in the form of inflation-linked bonds.

Debtors can only inflate their way out of debt if the rate of interest is less than inflation. In the UK, for example, at one point during the mid 1970s, the real rate of interest was minus 12 per cent.

This is why some argue that this whole deflation thing is a con. The Fed is trying to fool markets into failing to spot that the inflation genie is out. In truth, markets are too cynical to be taken in so easily.

The Fed could of course create money, and create trillions of dollars of money and buy government debt at zero interest rates. But the snag with this approach is that it would be impossible to reverse. The Fed is required by the Federal Reserve Act “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” To deliberately create inflation via quantitative easing would require a change in the Act.

Such a change would have such calamitous implications that not even Uncle Sam could come through the other end without risking relegation to Third World status.

According to the BRC, non-food inflation fell at an annual rate of 1.4 per cent in June to just 1 per cent in July. Month on month the non-food inflation rate was no less than 0.6 per cent down on June.

Overall, shop price inflation was 1.5 per cent in July, the same level as last month. But the month on month rate has now been minus 0.1 per cent for two months in a row.

Stephen Robertson, British Retail Consortium Director General, said: “Shop prices have remained stable largely due to aggressive discounting driving non-food inflation down to its lowest rate since November 2009. The price of furniture and flooring fell for the first time in seven months.”

BRC said: “Our central view remains that the past period of high and volatile shop price inflation appears to be over for now.”

So far, so good. But then the picture takes a turn for the worse. Food inflation jumped no less than 0.9 per cent in the one month, with the annual rate rising from 1.7 to 2.4 per cent.

Mr Robertson put it this way: “Food inflation was higher than the previous month – driven by global factors putting pressure on the cost of fresh food, such as meat and fruit. The recent dry weather has increased the price of animal feed and poor harvests have reduced some fruit crops.”

But he saved his most significant words to last: “Problems with production in large wheat exporting countries such as Russia and Canada,” he said, “could put pressure on overall food inflation in the coming months.”

We like that: “could put pressure”. The truth is, at the moment wheat is shooting up in price like a rocket on fireworks’ night.

Russia has been hit by drought. Some say it is the worst drought in the land of the bear in the 130 years for which there are records. Wildfires have had a devastating effect on Russia’s food crops, and around one-fifth of the crops have been destroyed.

The trouble is, Russia is the fourth largest producer of wheat in the world, and third largest exporter. The rest of the former Soviet Union has been affected, too.

 As a result, the cost of wheat rocketed by 38 per cent in July, the biggest monthly gain in the price of wheat since 1973. Prices hit a 22-month high earlier this week. This will inevitably provide yet another inflationary shock across the world. There will be a knock on effect if consumers opt for bread substitutes such as rice, instead of bread products, which would push prices up across the board.

You can see why the inflation hawks are so sure inflation is coming back with a vengeance. It is all very well saying wheat, just like rising oil or VAT hikes, are one offs, but if we keep getting one offs surely inflation will become entrenched.

Well, there are two ways of looking at this.

Inflation only becomes a problem when wages start to rise. For as long as wages stay low, the rocketing price of wheat simply means we are worse off, and under these circumstances there is certainly no need to increase interest rates or reverse quantitative easing.

The concern is that we get so used to these one-off effects, that wages start to rise in anticipation of inflation. Even the BRC, so long a fan of cheap interest rates, has started fretting about this, and in its latest report on shop price inflation stated: “It is vital that the Bank of England’s target rate remains credible and households’ expectations do not become entrenched above the 2% target. The risk is that higher expectations may lead to employees demanding higher wages, leading to a wage-price spiral. Under which, employees demand higher wages, firms put up prices to pay for these wages which inevitably leads to higher inflation, higher wage demands – the cycle continues.”

But we would disagree, and this is why.

Firstly, we are set to see a wave of job losses in the public sector. This will create more spare labour, and reduce the chances of wage inflation.

Secondly, the Russian drought will not last for ever. Supplies of wheat will rise again. Indeed, some producers may respond to the price hike by investing in more capacity. Price will fall back, reversing the current inflationary effects.

But more important, there is a very real danger we panic into taking anti inflationary measures. Liken the economy to an inefficient shower you are not used to. The water is too cold so you turn up the hot tap, but unknown to you the water was getting hotter anyway, and all of a sudden scalding water pours forth.

The Bank of England needs to keep its nerve, and not let itself become unsettled by the growing chorus of voices claiming inflation is inevitable.