Is stagflation back to haunt us?

This week, however, its chairman, Bank Governor Mervyn King, spoke at some length about the threat posed by the credit crunch to the wider economy.

His thesis was that a sharp economic slowdown was likely, and the implication of his remarks was that a series of interest-rate cuts would be necessary to mitigate the effect of that slowdown.

Hearing this, most people jumped to the conclusion that interest-rate cuts could start as soon as next month, but this overlooks one crucial fact. The MPC's mandate is to target inflation, not economic activity. So while rate cuts might be needed to boost the economy, it is not the MPC's job to deliver them - unless its brief has been changed without anyone being told.

This is more than a semantic point because there are powerful reasons why inflation may be up next year, and the MPC may not be able to cut rates if it is. In fact, we could quite well have something not really seen since the 1970s, which was then known as stagflation - a combination of stagnant economic growth and inflation.

There are so many reasons to worry, starting with food prices. The increased affluence of Asian countries and the diversion of food production into crops for biodiesel have caused a huge surge in food prices that gives no sign of lessening. Stables such as milk and bread are showing the kind of increases no one has seen for 30 years, and food may once again become a significant item in household budgets.

Similarly, the oil price seems stuck at around $100 but a raft of other commodities are also at record high prices, putting up the cost of raw materials worldwide. Energy and raw-material costs affect everyone and everything in the end, and must ultimately come through to the consumer.

Third, there is sterling. Many have been seduced by the high rate of the pound against the dollar, and think the currency is strong. It is in that narrow sense, but it has been slumping against other currencies, and is at its lowest for years against the euro. It just needs to lose a bit of ground against the dollar as well, and it will no longer provide the insulation against global price rises that have been such a feature of recent times. A falling pound always means rising inflation.

It may be that none of these factors will matter, and they and the inevitable rises in fares, council tax bills, insurance premiums and utility costs will be shrugged off by the phlegmatic British worker who will stoically continue to show wage restraint.

But that surely is not the way to bet. We should at least be alive to the risk that higher inflation is a distinct possibility, an economic slowdown is similarly likely and if we are really unlucky we will get both at once - and there is very little the Bank can do about it.

Guy Hands, boss of Terra Firma and one of the best-known figures in private equity, has a habit of using his speeches to tell it like it is - and it was a pity that his colourful remarks about how bankers hit by losses on subprime loans were whimpering like dogs distracted attention from his broader message in a speech he delivered in Paris on Wednesday.

He warned that not only are times much tougher for private-equity firms, but also the whole economy was likely to suffer and a lot of existing private-equity financed businesses were likely to run into trouble. He believes that the credit crunch is not a blip but that it will be with us a long time and spill into the broader market - as indeed Bank of England Governor Mervyn King similarly implied this week.

According to Hands, the credit squeeze has destroyed two of private equity's three big advantages. First, because debt was cheaper than equity, it was possible to buy listed businesses with borrowed money and use the company's cash flows to service the debt, but this has become almost impossible because debt is no longer so cheap nor so freely available.

Second, asset values and stock-market prices are no longer floating ever higher on this rising tide of cheap money, so it is no longer possible simply to buy companies on one multiple, wait a few months for the markets to go up, and then sell them back to the market on a higher multiple. The loss of these two sources of financially engineered profit means that in order to make money the industry will have to fall back on its ability actually to improve the profitability of the businesses it buys, which indeed is Hands' third factor - the ability of private equity to deliver increased earnings through enhanced operational efficiency.

This has always been the most debated and debatable of the industry's skills, and is now going to be even more sorely tested, says Hands, if or when the credit squeeze begins to have an impact on the wider economy. Interestingly, the wider implication of this point still seems largely to be lost on stock-market investors, who believe that equity valuations will be underpinned by the falling interest rates the Bank of England has hinted are highly likely for next year.

Hands' comment is a useful reminder that the reason interest rates may come down is that the whole economy may soon begin to slow. That means companies will face tougher trading conditions, and their profits will be squeezed. How that can be good for share prices is a mystery, even with lower interest rates.

That is underlined by his final point, which was that investors whose skill is buying distressed companies would be awash with opportunity in the next couple of years as over-leveraged buyouts that were put in place last year and in the first half of this one come up to the time when they have to start repaying some of that debt.

This is more a problem for 2009 than 2008 but whatever the date, the combination of higher interest rates and a slowing economy mean some of them will not be able to make the payments. The tougher economic conditions become, the more companies will fail - and not just in private equity-backed vehicles either.