The European Central Bank (ECB) today defied the threat of recession in many eurozone countries and raised interest rates to their highest level for almost seven years, despite frantic political pressure.

ECB President, Jean-Claude Trichet, issued a strong warning on Wednesday that inflation in the zone could explode if left unchecked.

The decision by the ECB’s Governing Council is set against calls to hold firm from European leaders led by President Sarkozy of France. It comes after a leap in eurozone inflation to 4pc in June which set alarm bells ringing over price pressures. This was further fuelled by a rise in factory-gate producer prices within the eurozone, which jumped 1.7pc in May, to stand 7.1pc up on a year earlier. The hike was largely driven by an 18.2pc year-on-year rise in energy costs.

More depressing numbers were released today confirming that the eurozone’s services sector, which is at the heart of its economy, shrank in June for the first time since mid-2003.

Economists pointed out new indications of “stagflation” in the eurozone economy, with output contracting as price pressures continue to build. They believe that today’s interest rate increase is a single-shot for the rest of the year.

Could that be more in hope than expectation though?

In what seems to be a concerted action by the UK Treasury and the Bank of England, Bank Governor Mervyn King warned that pay demands for inflation-busting increases will be self-defeating if they trigger a rise in interest rates.

The Governor told the Treasury Select Committee of MPs that there is no magic bullet to protect workers from having their incomes squeezed by rising prices and interest rate increases. They could help themselves by avoiding excessive pay claims to cover the rising cost of living.

Cash-strapped families will find no shelter this year from rocketing oil and food prices.

“We are all in this together,” he said. “The most important thing is there’s no magic bullet that will protect the UK from higher oil and food prices imposed by the rest of the world. It is better than we face up to that now and recognize that fact, rather than pretend to ourselves that we can avoid it.”

MPC member, Tim Besley, said: “We have to adjust our living standards. One of the mistakes we can make collectively is to believe that by bidding up our wages we can somehow insulate ourselves from a global phenomenon - rising energy and food prices. If we do that that is a self-defeating process which will lead to higher inflation and wages will not end up being higher.”

Mervyn King said, “The cost of reducing inflation once it stays above the target for a period will be a very prolonged and deep slowdown in activity.”

With the housing market in meltdown, the next three years are set to be painful for everyone, with the possible exception of short sellers on the markets and the oil companies.

Ordinary folk need to batten down the hatches now, cut expenses to the minimum and protect their income sources as best they might. It’s not in the interests of the High Street, of course, but, for a few years at least, it’s everyone for himself.

One thing’s for sure, conditions will take the focus off rather abstract globalization matters, back to the real, local world that everyone lives in.

Around the world, government and central banks are thinking less about the possibility of deflation and increasing turning their attention to inflation.

But how much do we know about the causes of it, and why are some governments getting it all wrong?

Take the British Chancellor of the Exchequer (Finance Minister), for example. Alistair Darling recently said, “Pay awards in both the public and private sectors have got to be consistent with our inflation target of two per cent.”

It was like going backwards in time to the 1970s when a Labour government literally brought Britain to its knees by exercising almost total control over the economy.

Darling’s reasoning is that if pay rises were higher, prices would go up and consume the value of higher pay.

For a correct analysis of inflation, we have to turn to a former Conservative Health Minister, Enoch Powell, who knew a thing or two about economics. He said, “Of course when there is inflation, prices rise, including wages, which are the price of labour. That is what inflation means; the statement is a mere definition. But it is as absurd to say that inflation occurs because prices rise as to say that it rains because the ground gets wet. You cannot have rainfall without the ground becoming wet; the one is inseparable from the other; but we do not mistake the result for the cause.”

If that isn’t the most concise and accurate explanation, it must come very close.

His alternative to Labour’s prices and incomes policy approach would be to take money out of circulation by the government spending less or the Bank raising interest rates, or a combination of both.

In Britain, growth is at present around 2pc, and is likely to fall to about 1.3pc in the coming year. Inflation, according to government approved figures is about 3.5 per cent. That gives a total of 4.8pc.

Compare that to a rise in money supply (M4) of 12pc and there you have it.

Inflation is caused by having too much money chasing too few goods. And it’s the government that injects that money into circulation, partly by excessive borrowing.

The UK will now have to take money from the economy going into a possible recession — the worst of all possible worlds.

Still no good news on the macroeconomic front.

American investment bank Goldman Sachs believes that America will lead Britain and Europe out of the credit crunch.

In many ways that’s a statement of the obvious since the U.S. economy is usually nine months to a year ahead of its transatlantic partners. And whereas Ben Bernanke at the FED and the Government in Washington have pulled out all the stops to limit the damage, Britain and the eurozone have been slow to react and have concentrated their fire on the dangers of inflation.

David Viniar, Chief Financial Officer at Goldman’s said, “March was the low point up until now, but if I try and predict the future, I am likely to be wrong.

“Do I think we are through? No, I don’t, but I think there is a lot behind us. Now there is less concern about systemic liquidity risk. People are focused individual investments and credit.”

The real danger now appears to be inflation, driven by oil and food prices. That would be reduced by a worldwide downturn. Experience tells us though, that once inflation sets in, it’s a long hard slog to get rid of it, simply because the remedy is recession itself.

Goldman Sachs appears to be enjoying a “flight to quality” effect as the economic downturn hits America. Its position is strong, since it seems to have avoided the worst losses in the structured investment vehicle scandal. Investors now see the bank as a safe haven.