Commentary: As prices continue to rocket, how much more pain is there to come?

Some 11 years after Gordon Brown cut the Bank of England free from the apron strings of the Treasury, the system of independently- set interest rates faces its toughest test.

The Bank must balance its role as the nation's official inflation fighter, at a time of surging prices, against the need to prevent the economy sinking into recession.

As the Governor Mervyn King's letter to the Chancellor Alistair Darling makes clear, he is acutely aware of the dilemma.

The concern must be that if prices continue to rocket, a wedge will be driven between the Old Lady of Threadneedle Street and the Treasury  -  leading to an open dispute on how to conduct policy.

Such a split would undermine the whole rationale of giving the Bank its independence and almost certainly send the pound and share prices plummeting. The markets hate uncertainty.

But it will require an immense amount of restraint from the Prime Minister, who set up the current system, to resist interference  should the interests of Labour and the Bank diverge too far.

Above all, Mr Brown will be looking for the seeds of an economic upturn by the time he goes to the polls in just over 18 months.

The Monetary Policy Committee will be determined to bring inflation back within target even if that means keeping interest rates high.

Such a stand-off would certainly lead to calls from the trades unions and the Left for the Government to reclaim some of the rate- setting powers it divested to the Bank.

However, any steps to weaken the Bank or to ease the inflation target should be firmly resisted if ministers-want to avoid a return to the double- digit prices rises of the 1970s and late 1980s.

With consumer price inflation (the Government's preferred measure) likely to climb to 4 per cent  -  twice the official target  -  over the next two years, the Bank should be bearing down hard.

The only direct weapon it has to bring inflation back within target is to raise the official bank rate.

But that would almost certainly be disastrous for every consumer  -  putting pressure on mortgage lenders, who are already severely rationing loans, to raise the price of mortgages even further.

The risk would be an uncontrolled downward spiral in house prices, as well as arrears, repossessions and mayhem on the High Street.

In his letter to the Chancellor, Mr King does his best to allay fears that the Bank  -  which is holding official interest rates at 5 per cent  -  will do anything too dramatic.

He notes that the main reasons behind the exceptional surge in prices are global.

As every motorist and homeowner knows, world oil prices at $132 a barrel have increased the cost of petrol at the pumps and domestic fuel bills. This has been accompanied by a surge in basic food prices with the cost of bread and milk soaring as global demand rises.

The Monetary Policy Committee, for all its firepower, can do very little about these external events.

Mr King's greatest fear is that headline price rises start to infect the sinews of the economy.

Indeed, the latest survey of fears about inflation, carried out for the Bank of England, suggests that prices are expected to rise to 4.9 per cent. This worry could become dangerous if it influences wage-bargaining strategies.

Currently, wage deals are sensibly being settled at an average of about 3.2 per cent which suggests that the public has learned from the past.

But the recent rash of such disputes, including that involving Shell tanker drivers and some public sector unions, raises the possibility that the dam could burst.

If that happens, Mr King and the Bank of England would have very little choice but to consider raising interest rates at a time when the economy is slowing.

If that happened, we would have the worst of all worlds  -  surging prices and wages; an economy heading for recession; plunging house prices and rising unemployment.

After a decade of non-inflationary growth, such a scenario doesn't bear thinking about.