Why savers should return to Northern Rock

I've never been one for tying my money up in long-term products of any kind. But I'm beginning to find myself looking rather longingly at some of the fixed-rate savings bonds on offer.

Right now, Birmingham Midshires will pay you 7.17% if you hand over your money for a year and Skipton Building Society will give you 6.99% for three years. Want more? Northern Rock will give you 7% for five years.

That sounds pretty tempting given that with the retail price index (RPI) at 4.2% a lower rate taxpayer would have to be getting nearly 5.25% in interest on their money just to be able to buy the same quantity of goods at the end of the year as at the beginning, and a higher rate taxpayer would need to make at least 7% (after both inflation and tax are taken into account). There just aren't any other "safe" investments that can pay this much the best rate of interest you can get on an instant access account these days is 6%.

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The Northern Rock offer also makes sense because, unlike all the other banks and building societies overexposed to the end of the property bubble, its deposits are still 100% government-guaranteed.

So go with one of these fixed-rate bonds and at least you have a good chance of ending up evens, or of actually making a real return on your money. And if inflation turns to deflation, as some think it will, you have a chance of making a very good real return indeed.

Right now, all the signs point to continued inflation. Food prices are rising fast up 7% in May alone says the British Retail Consortium (that's £50 per average family). The price of imported goods into the UK is also rising at a rate of 8.6%, a trend most analysts expect to continue as surging demand from emerging economies pushes up all commodity prices and as wages in developing countries keep rising. Then there are wages in the UK to worry about. If these can be controlled so can inflation, but with consumers squeezed between rising commodity costs and higher mortgage payments they aren't going to take falls in their real wages however short term the Bank of England might say they will be lying down.

No, workers will surely have a go at demanding more. Just as they are in Europe. There, Jean-Claude Trichet, chief of the European Central Bank, has noted the 3.3% rise in hourly labour costs in the first quarter of this year and started to warn of the dangers of this kind of second round inflationary effect: rising wages means rising costs which in turn means rising prices and then eventually even higher wage demands. Add it all up and there is every reason to think that the consumer price index and RPI should keep rising for now.

But while we should be very nervous about all this, there is a chance that it won't last more than another 18 months or so. Why? Because to a large degree the inflation we are witnessing now is a function of the large amount of money sloshing around in the financial system, itself a function of years of very low interest rates and of a vast lending boom across the west a credit bubble.

China could not, for example, be driving commodity prices higher in the way that it is had its export industry not been so boosted in the first place by credit-financed consumption in the US.

But this period of monetary expansion could be over. Lending is contracting very fast indeed in the west. Bank balance sheets are under enormous strain everywhere and bank shares couldn't be doing much worse. So there is very little appetite in the financial system for shovelling money into the hands of binge shoppers, property lovers, big investors or, for that matter, even small businesses either here or in the US.

At the same time, consumers have turned from splurgers to scrimpers in a matter of months as their living costs have soared, their household wealth collapsed along with property and share prices and their employment prospects became more bleak.

Look at it like this and as someone said to me recently, the inflation we are currently seeing is the 'echo' of the credit bubble of the first part of the decade rather than something reflective of the state of the global economy right now. The end of it could see consumers too nervous to demand wage rises and possibly stopped from having to do so by a collapse in commodity prices anyway. Add in a nasty recession in the UK, in Europe where the industrial production data is looking too weak for comfort, and in the US and it is entirely possible that by the end of next year we'll all be praying for a touch of inflation.

Expect, says Christopher Wood, an economist at CLSA, the Hong Kong-based brokerage house, "the unwind of structured finance and the related dramatic deleveraging precipitated by the housing market" to "prove to be much more deflationary phenomena in 2008 and 2009 than the cost push inflation generated by commodities."

It is hard to know exactly when the current inflationary environment will tip into a deflationary one but if it happens (and this is still an if), the Bank of England, along with other central banks, will stop threatening rate rises and slash them fast instead, making the 7% five-year offer from Northern Rock look like one hell of a deal in retrospect.

Just imagine how clever you might feel if you were getting that on your cash when base rates were down to, say, 2% by the beginning of 2010?

And even if we don't end up with real deflation, where else are you going to put your money in this environment? Not the property market. Not the stock market and not with any real confidence in the short term the commodities markets. Perhaps we should all be queuing at Northern Rock again this time to put money in rather than to take it out.

This article was first published in the Financial Times