“Is Britain going back to the 1970s?” asks Ben Traynor in Fleet Street Daily.

I was 14 when I first learned about the 1970s oil price shocks, and how they had caused stagflation (unemployment and inflation rising at the same time) in Britain.

In a nutshell, here’s what I was taught: the higher cost of oil meant Britain had to pay more for its fuel. This represented a transfer of wealth from oil importers like the UK to oil exporters like the OPEC nations.

Unfortunately it took time for people to cotton onto this. They saw their cost of living rising, and wanted to be paid more. Unions threatened to strike if they didn’t get their way. The government tried to stimulate growth in the economy, hoping this would make the problems simply go away. But they didn’t.

All that happened is we got inflation — nature’s way of forcing us to buy less when we refuse to accept that we’re poorer.

Britain entered a wage-price spiral, which fuelled higher inflation. Eventually we had to be bailed out by the International Monetary Fund.

By the end of the decade, Britain had both high inflation and high unemployment (usually the two are inversely related).

I realise this is a somewhat simplistic précis. Economic history is far more nuanced than this. Nevertheless, the broad strokes of this story made sense to me as a 14-year-old.

And they still do. Which is why it was heartening to hear that JCT seems to share my view of what went wrong in the 1970s:

“In the first oil shock, we took wrong decisions and embarked on second round effects and tried a high level of inflation for a long period of time,” he said.

“We created by our own absence of lucidity mass unemployment in Europe when before 1974 we had no mass unemployment. Price stability, and credibility in price stability, in the medium term, is the best way to have a high level of sustainable growth and sustainable job creation.”

Indeed, it was the lure of sustainable growth and sustainable job creation that led Gordon Brown to grant operational independence to the Bank of England in 1997, his very first act as Chancellor.

But there’s evidence that the Bank is losing the “credibility in price stability” battle. Inflation expectations are on the rise; the FT today writes that investors are more sceptical of the Bank’s ability to tackle inflation than at any time since it gained independence.

The Bank only has itself to blame. It has cut interest rates this year despite the fact that inflationary pressures are rising. Its reasons for doing so are understandable — Britain’s economy is on the rocks.

But that doesn’t change the fact that fighting inflation should be the Bank’s number one priority.

The Bank isn’t helped by the fact that its inflation target is measured by the Consumer Price Index (CPI). CPI annual inflation was at 3.0% last month, right at the upper limit of the Bank’s target zone.

But we in Britain know full well that the prices of what we buy are going up more than that. Small wonder the Bank is losing the battle for hearts and minds.

If the Bank went all out and targeted inflation properly, we’d quickly feel poorer. But that’s the point — we are poorer.

Prices of commodities we buy are going up around the world. As both Trichet and my economic teacher would gladly tell you, this represents a transfer of wealth away from Britain to those countries exporting the stuff the world needs.

Ben gives some background on why prices are rising in Britain – in a word, inflation:

Inflation is the natural consequence of a weak currency. The principal reason for this is that a weak currency makes imports more expensive. This is exactly what’s happening in Britain – everything from food to energy is getting dearer. If the ECB puts its rates up, more money will head into the euro, further weakening the pound. Unless… unless the Bank of England also raises rates. Truth be told, the Bank should raise rates anyway. At July’s meeting they should announce a rise of 0.5% at least.

Not that they will. Because today we have yet more ‘bad data’ from the housing market. House prices are falling twice as fast as they did in the early nineties. According to the Halifax, house prices fell by 2.4% last month, to add to the 1.3% fall we had in April and the 2.5% fall in March.

Since January, the average house is worth 6.6% less. That works out at a not-too-clever £13,000 (Yesterday, Theo took an in-depth look at the housing market, calculating housing’s “P/E ratio”)

So an interest rate megahike is unlikely. But one thing is certain – the Bank of England can’t save the housing market. So it shouldn’t try.

Predictions time! When can we expect rates to start rising? For July, I reckon the Bank will stay put, leaving rates at 5%. Of course, that all depends on a) how much deflationary data we get this month, and how much the Bank can stomach, and b) whether or not the politicians try to meddle, and how successful they are if they do.

Milton Friedman once wrote that inflation is a problem because the more volatile prices are, the less efficient is the price mechanism. Because no-one knows what’s going on.

As he put it: “The broadcast about relative prices is, as it were, being jammed by the noise coming from the inflation broadcast”.

By August I think that noise will become too loud for the Bank to ignore. And then we’ll see some action (though probably only of the quarter-point variety; they’re cautious, these central bankers).

From our perspective, then, it’s as you were. Little succour in sight for the UK economy. But a possible chink of light that the Bank may, by hook or by crook, soon begin to start taking inflation seriously.

The report predicts that UK house prices will crash by 10% by 2010 and that, with consumer spending slowing, the Bank of England will eventually need to cut interest rates by three-quarters of a percentage point to 4.25% next year.

Ben Traynor in The Daily Reckoning explains how a house price crash in the UK will affect the country’s economy…

It never rains, it pours. Hot on the heels of the Bradford and Bingley saga, we wake up today to the news that mortgage lending has hit a record low.

Just 58,000 loans were made last month. That compares with 64,000 in March and 113,000 in April 2007. House prices will keep falling. But they’ll take their time — the market is drying up, with many would-be sellers pulling out of deals rather than dropping their prices.

It’s like a massive staring contest between buyers and sellers. Who will blink first? My money’s on the sellers — once they realise prices aren’t recovering any time soon, they’ll bite the bullet and drop them. Just a little bit… Then a little bit more…

So what’s the upshot for the housing market? A ‘soft landing’ or a short, sharp shock? And what about the economy?

Let’s start with housing. Fundamentally, houses are too expensive. But it’s hard to say how far and how fast they’re going to fall.

It all comes down to affordability. In theory, it should be easy to calculate the ‘correct’ level for house prices. How much do people earn, and what multiple of that can they affordably borrow? Run the numbers, and you get an idea of where house prices ‘should’ be.

But here’s where it gets tricky. We can get wage data pretty easily. But many would-be buyers have other capital to draw on. First-time buyers regularly rely on borrowing from parents, for example.

And besides, many current homeowners have demonstrated they’re all too willing to buy at a price considerably above what they can afford. Who’s to say the rest have learned from their mistakes?

Both of these factors make it hard to say exactly how far house prices need to fall to be ‘affordable’. But the good news, from our perspective, is that it doesn’t really matter. We’re confident we know which way they’re going, and that tells us a lot when it comes to where we should (and shouldn’t) invest.

Let’s move onto the wider economy. If house prices are coming down slowly, does that mean a ‘soft landing’ for the economy too? And is this preferable to a short, sharp shock?

Again, I think it’s going to take its sweet time sorting itself out. And here’s the kicker — the longer it takes, the greater the likelihood of a recession. I’ll explain why in just a second.

First, I want to answer the question of which we should be rooting for — the gentle decline or the brutal shock. My terminology is deliberately chosen to reflect the way I suspect the Government will view it.

The argument against a short shock can be summarised in one word — hysteresis. Hysteresis is the economic phenomenon of path dependency. A shock, so the argument goes, sets in train a series of events that can become self-sustaining.

An example would be long-term mass unemployment. If a large number of people are put out of work in one go, not all of them will find alternative employment quickly. Those that don’t will become deskilled, demotivated and will find it harder to get back into work. The shock, therefore, delivers its own persistent structural problem.

I think this argument has a lot of merit. But I still believe facing the inevitable, and quickly, is the preferable course of action. It all comes down to our irascible, temperamental friend Sentiment.

The longer this uncertainty drags on, the more entrenched negative sentiment will become. This will make a recession not only more likely, but more difficult to get out of.

Sadly I reckon this is exactly the scenario we’re facing. A long, drawn out recession. A few false dawns, with everyone, their confidence battered, scurrying for cover again at the first wobble.

The investment lesson is clear. Avoid companies with a high level of exposure to the British consumer. This would include most banks and retailers.

Put your money with firms whose profits aren’t wholly dependent on the spending habits of Mr and Mrs UK.

Because Mr and Mrs UK are about to go into hibernation…