Could interest rates be on the way up, reversing the two cuts in rates earlier this year? 

With inflation at 3.3 per cent, well above the official target of 2.0 per cent, and rising, the normal reaction of the Bank of England would be to increase interest rates to dampen demand.  But, in a letter to the Chancellor, Bank Governor, Mervyn King, said: "There are good reasons to expect the period of above-target inflation we are experiencing now to be temporary". 

The Bank calculates that almost all of the increase in inflation from 2.1 per cent to 3.3 per cent so far this year is down to higher food and fuel costs.  This, it says, is not a generalised rise in prices driven by higher spending but the effect of international factors that an increase in rates would not control.  Mr King points out that spending is in line with average increases seen since 1997, that the growth in money supply is slowing and that credit availability is shrinking.  There is also growing evidence that the economy is slowing sharply.

If the Bank is right, inflation should peak at the end of this year and start to fall back next year, even without an increase in interest rates.  Given the continuing rise in oil prices, the headline figure will rise further this year and higher commodity prices will keep inflation above target well in to 2009, but Mr King told the Chancellor that it should be back to 2.0 per cent in two years.  

The Bank accepts that it could act more aggressively to bring inflation back in to line much sooner than the two year time horizon but says that: "The result would be unnecessary volatility in output and employment".  In other words, the economic pain required to bring inflation under control faster would be too great and is not necessary.

So, despite soaring inflation, the Monetary Policy Committee (MPC) could decide to leave rates as they are.  That was certainly their decision at their last meeting when all but one of the MPC members voted to keep rates on hold and one, David Blanchflower, voted to cut rates by 0.25 per cent.

But the Bank also warned that it would push rates higher if it saw signs that the prices of other goods (not energy or food) started to rise more quickly.  If employees and retailers seek to compensate for higher energy and food costs by demanding higher wages or increasing prices across the Board, the Bank will step in and raise rates to damped demand.  In effect, we have a choice, accept that prices will rise faster than incomes or cope with higher interest rate later.  The key measure for the MPC at the moment, it seems, is not the headline inflation figure but the data on income growth.  If earnings start to rise sharply, expect rates to follow them higher.