For the fifth time this year, the Bank of England raised interest rates to a 6 year high of 5.75% over concerns about inflation.

The trouble is, many people, including the UK government and the Bank of England, do not understand inflation.

Well, they may understand it perfectly well, but pretend not to because the fact of the matter is, inflation cannot really be stopped by raising rates. Inflation is caused by inflating or increasing the size of the money supply, i.e. printing more money. The printing of fiat paper currency with nothing backing it, such as gold did in the times of the gold standard, allows governments to pay for things they cannot really afford and allows politicians to buy their own re-election.

As there is more paper money in circulation there is more money chasing after the same amount of goods and so we see a rise in prices. Many people usually define inflation as “when things go up in price” but they do not understand the mechanics behind it.

So when the Bank of England or the Federal Reserve raise rates, they are not “combating inflation” at all. To fight inflation you just need to stop printing money and preferable have your currency backed by something of real value such as gold bullion. When rates go up, all it means is that it is less attractive to borrow money and spend it, so less people borrow and spend, so there is less spending in the economy. As there is less spending and therefore less trade, so rising prices are less obvious to consumers and various inflation watchdogs can come out with pathetically low figures of inflation such as 2-3%.

The Bank of England cannot simply keep raising the rates as it will cripple the UK economy, especially housing. Borrowing costs for housing have increased 125 base points since August last year and personal bankruptcies are already at record levels.

We think that governing bodies will continue to raise interest in the near term, but they will be forced to lower rates once their respective economies suffer from the high cost of borrowing being forced upon them. Remember one of the main reasons why the UK and Western economies in general have been doing so well for so long is because they have had access to cheap credit, that they have spent fuelling economic growth. Once governments start lowering rates, this will cause a last gallant rally in the DOW, FTSE and other major stock market indices. This final rally will be the last leg up before the crash, rescession and perhaps even a depression that will follow.

As rates are dropped, gold and precious metals will rise as the currencies weaken and people begin to see inflation run amok. As the stock market goes into decline, people looking for a safe haven will flood into gold and precious metals as well as gold stocks and silver stocks.