Get ready for a 6% UK interest rate

Just yesterday, we were writing that the UK commercial property boom seems to be over.

Last night, we got an email from Capital Economics outlining when the bust will begin.

The economics consultancy, headed up by Roger Bootle, had previously foreseen a gentle slowdown. But it now reckons that "the commercial property market is no longer likely to avoid meaningful falls in capital values over the next few years." The group thinks prices will fall by 4%-6% in both 2008 and 2009, with further falls in 2010, meaning that, over those three years "total returns at the all [commercial] property level will be approximately 0%."

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CE has always tended towards the bearish side on residential property, but this is the first time it has come out negative on the commercial side.

So what made the group change its mind?

It seems that David Blanchflower, hitherto the most dovish' member of the Monetary Policy Committee, has finally alerted the City to the dangers of inflation.

Blanchflower has voted against all three previous hikes, and actually voted for a cut in March. But the minutes for May's rate-setting meeting showed that the entire MPC voted for the quarter point rise to 5.5%. And a few even considered a half-point hike, as yet unseen in the MPC's entire ten-year history.

The minutes prompted interest rate outlook upgrades across the Square Mile, with most analysts now expecting a further rate rise as early as next month. Capital Economics - who not so long ago expected rates to be falling rather than rising - declared that interest rates will reach 6% in August.

And if rates go up to 6%, that makes the yield on commercial property - already below the 10-year gilt yield, also known as the risk-free rate - look appallingly low. Why put money into a risky and cyclical asset class like commercial property, if you can get a better return for less risk by putting it into Government bonds?

So that means property yields have to rise, or gilt yields have to fall. With interest rates rising, gilt yields won't be going anywhere but up - so the property yields have to rise to match. And for property yields to rise, you either need higher rents, or falling capital values, or both - and the most likely outcome is falling prices, as investors start to realise that commercial property simply isn't worth the risk anymore.

We've consistently said that everyone has been underestimating inflationary pressures and the likely impact on interest rates. And we reckon they still are. As James Ferguson keeps pointing out, the last time inflation was this high, the Bank of England reckoned that interest rates of closer to 8% were more appropriate.

But despite the warier mood in the City, plenty of commentators and analysts are still sceptical about the ability of food and energy prices to stay high, and thus there's still that sneaking suspicion that inflation must surely come down at some point - its just a matter of staying calm and holding on tight.

But by now it should be clear that this is simply deluded wishful thinking. Oil prices are still floating around $70 a barrel (about 30% up on the start of the year). The majority of pundits and certainly the Bank of England had expected a fall by now, perhaps to around $40 a barrel. But oil just won't co-operate.

Then there's food. Rising costs here are beginning to make themselves felt. Already annual food price inflation in the UK is at its highest level - 6% - in nearly six years. US chocolate giant Hershey cut its 2007 profit forecasts this month because of rising milk prices, says the FT; while Nestle has told investors that it will "not be able to cope with higher milk costs simply by raising prices."

John Parker, a food analyst at Deutsche Bank, told the FT: "There is growing concern within the food industry that the present upswing in soft commodity prices is structural rather than cyclical."

In other words, this rise is here to stay - it's not just going to go away if we simply cross our fingers and pretend it's not a problem, as most people have been doing with oil prices for the past three years or so.

You can read much more about food price inflation, its causes and how to profit from it in a recent cover story by my colleagues Tim Bennett and Jody Clarke: How to profit from rising food prices

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Turning to the stock markets