The Bank of England must cut rates now

Prices are rising and, worse still, the Government is demanding that we accept pay rises below the rate of inflation. Now the Bank of England is threatening to raise interest rates to control prices. That means less pay and possibly higher interest rates just when the cost of living seems to be rising exponentially.

We face this worrying scenario because, according to classical economics, you constrain price rises and control inflation by limiting demand. One way is by raising interest rates which makes credit (such as loans and mortgages) more expensive, meaning consumers have less money to spend. Governments also try to ensure that wages don't chase prices such that we demand more cash to pay for the rising cost of living. This would pump more money into the economy and stimulate demand, creating what economists call a 'wage price spiral'. Thus, our leaders tell us that we must curtail our pay claims in order to bring price rises down to an acceptable level.

But this is a recycled right-wing economic theory that no longer applies to the current economic situation. Very little of the rise in prices is caused domestically, so suppressing UK demand will have minimal impact on inflation. On the contrary - and in this the Chancellor and the Governor of the Bank of England are right - current inflation is mostly caused by vast international prices rises: the huge increase in the price of oil (up 80 per cent in a year), wholesale gas (an astonishing 160 per cent) and world agricultural prices food etc (60 per cent). Other commodities such as metals have risen markedly and, with sterling depreciating by 12 per cent over the last year, all these imports have become even more expensive.

This feeds through to British inflation, which according to New Labour's preferred CPI measure, is now running at 3.3 per cent - whereas RPI, which includes housing costs, is at 4.3 per cent. However, many people face a real inflation rate much higher than either measure. For those families who just buy the essentials, an inflation rate of 10 per cent is much nearer the mark.

Official inflation is only measured by the rise in the cost of a basket of goods. The real rate depends solely on the goods we actually buy. For instance the 1.5m households that rely on home heating oil have faced an increase of 84 per cent in their energy bills. For pensioners who spend more than 10 per cent of their income on heating (as many do), the household inflation rate will be that much higher.

Indeed for the millions of Britons who are just spending money on the basics - food, shelter and getting to work - prices have rocketed far above the offical rate. For example while food has risen by 8.7 per cent, staple items have risen even higher: milk cheese and eggs by 16.6 per cent, meat by 9.1 per cent and simple household butter by an astounding 31.9 per cent. The rate for working-class families is depressed by items they don't buy like fruit, which only increased by 2.4 per cent, whereas oils and fats, which they do consume, shot up by 20.1 per cent.

Similarly it is important to calculate the marginal impact of inflation rates on different aspects of household expenditure. For instance, on things like mortgages and rent, inflation has gone up by 4.8 per cent, which at first sounds OK until you realise that paying for housing takes the majority of any average wage earner's pay packet, so a small rise can mean hundreds of pounds extra to find each month.

Just earning the money to cover the basics has become an increasing struggle; house insurance and ground rent have risen by 12.5 per cent, water bills by 6.5 per cent and gas and electricity by 11.2 per cent. And, of course, even getting to work to pay the bills costs more: petrol has risen by 19.5 per cent. The latest news is that domestic bills will rise further - with energy expected to increase by another 40 per cent before Christmas. Year on year, the effects of these rises are compounded: gas has risen by 108 per cent since 2003, and electricity by 69 per cent in the past five years.

The items that have depressed the headline CPI rate - clothing, electronic goods and computers - favour students and teenagers who (being subsidised) avoid the real costs of living; thus, the real inflation rate facing ordinary working households is far higher than commonly supposed.

In which case higher wage demands seem wholly legitimate. According to neo-liberal ideology such claims should be resisted - but why? With inflation imported from abroad, wage increases are highly unlikely to increase inflationary demands since the price rises are so large that people will struggle to pay the bills anyway. Moreover the traditional outlet for disposable income - clothing, electronic goods, consumer durables - are those items that are falling in price, so any domestic demand would be non-inflationary.

In fact the Bank of England risks a far greater danger. Frightened by the right-wing myth of a 1970s wage price spiral, the Bank's monetary policy committee is threatening to deal with the new threat using the tactics of the last war and raise rates. But this will lead to stagflation (no growth and rising prices) rather than avoid it.

The only member of the committee who gets it is David Blanchflower who argued for an immediate interest rate cut. Facing imported inflation, a ballooning of personal debt and a collapse in the housing market, the bank should stimulate not depress demand.

If we can hold the economy together, Britain can wait until inflation passes through the system, let people get paid what they need and lighten the burden of mortgages. The risks of recession far outweigh an inflation we can't control anyway. Paradoxically, in the face of surging price inflation, the Bank needs to cut rates now or risk a full-blown economic meltdown. ·