How cutting rates will set the inflation trap

For a start, look at Libor, the rate at which banks lend to each other and the benchmark for so much commercial lending. Last August, when the MPC was considering putting up Bank Rate, the market did its work for it when three-month money shot to 6.1%, signalling (if only we'd seen it) the start of the Northern Rock crisis. The cuts since then have been slow to work through, but Libor is down to 5.61%, a significant cut in borrowing costs.

The MPC, it can hardly be said too often, is under orders to set rates to try to keep inflation measured by the Consumer Prices Index as close to 2% as possible, taking a two-year view. Since last August, the prospects for inflation in 2008 have got distinctly worse; oil has stayed up when many expected it to fall; the much-vaunted gas surplus never appeared and domestic prices are rising again; the boom in basic foodstuffs is only just getting under way and has hardly reached the shops.

Factory-gate prices are rising at their fastest for 16 years. Council-tax bills are going to compound the misery.

This is classic inflation, the stuff we experience every day, and explains why our fears are rising. They might be rising more, given that real inflation, measured by the Retail Prices Index, is already at 4%. Only the phoney CPI, which seems to exclude everything that goes up, signals a relatively comfortable 2.1%, offering the illusion that prices are not rising quickly, but employees are starting to see through this when making wage claims.

It could get worse. In the last month, sterling has been devalued by 6%. You can no longer buy a dollar for 50p, and the in-your-head exchange rate for the euro has gone from three for every two pounds to four for every three. As a result, the CPI might break through 3%, requiring another letter from the Bank Governor to the Chancellor in explanation.

As Thomas Dodd of HSBC puts it: "Two letters in two years could damage inflation credibility." He can say that again. A letter that followed a series of interest-rate cuts would destroy it, and might even precipitate the departure of the Governor.

The official policy now is to hope the shops will be forced to slash prices to keep inflation down, while bullying the MPC and the mortgage banks into cutting rates, and threatening the power companies. Such policies have a miserable history.

If only we hadn't endured a decade of Gordon Brown's smoke-and-mirrors economic policy, we wouldn't have the bloated public sector and gruesome gap between Government revenue and outgoings. The Europeans Brown always sneered at in Budget speeches have small deficits, giving them scope to raise public spending to stave off recession. The classic remedy for the state we're in would be cheaper money coupled with either higher taxes or less state spending, but just doing the easy bit risks runaway inflation.

The last time we were forced to take this unpleasant medicine, the result was 15 years of uninterrupted economic growth. The other result was the total eclipse of the party that imposed the policy. Things are not yet as acute today, but you can see why Brown is making pitiful calls for pay restraint to his armies of public-sector workers, while hoping desperately that competition and threats will do his dirty work for him..