EUROPEAN stock market indices have dropped 7% in seven days “largely on rate fears”. This means the wise guys who told us a year ago that American base rates would plateau at about 3.5% after 10 quarter-point increases have seen rates go to 5% in 16 steps and fear they could go even higher.

The Federal Reserve, under Ben Bernanke’s management, adopts a somewhat old-fashioned approach to its role. If the economy is powering ahead in real terms by close to 4% a year and if inflation in the single month of April hits 0.6%, then the correct policy response is to make credit more expensive.

We warned last autumn that a turning point in our fortunes had been reached but that the effects of higher interest rates would be masked initially by cash pouring out of special savings incentive accounts.

So what do trends in the global cost of credit mean for us now? The same wise guys who said American rates would plateau at 3.5% are now telling us to pencil in two further quarter-point increases in the European central bank (ECB) base rate between now and the end of the year. This would take the base rate from 2.5% to 3% by December.

With private-sector credit in this country growing by 30% a year and aggregate private-sector borrowing at about €300 billion, the correctness or otherwise of this prediction is a matter of no small importance.

Perhaps the wise guys are being overoptimistic again. If America pushed base rates to 6%, for example, would the ECB be happy with a 3% negative differential between US and European rates? And how does this explain the recent strength of the euro against the dollar?

Those who run the ECB probably would be more comfortable with a smaller differential between American and European rates. They have always harboured delusions that the euro could become the leading international reserve currency one day. And, like all central bankers, their primary focus is on the issue of inflation.

The omens are not good, with the much higher cost of energy yet to be felt across many products and services. The inflationary pressures in a full-employment, high-credit-growth economy like Ireland’s are particularly intense. The year-on-year increase in consumer prices (CPI) has already hit 3.8%. But the question everybody is asking is: how bad can it get?

Government ministers are quick to blame the upsurge on higher energy prices as they have increased from $50 per barrel to $70 in the past year, adding about half a percentage point to the index. They also blame higher interest rates that, they point out, are beyond our control. Borrowing costs make up part of the calculation of the CPI, and European base rates are already half a point higher than they were between 2003 and 2005.

There is some truth in these claims, but they should not confine their investigation to energy or interest rates. The cost of public services provided to the consumer, for example, rose 5.9% in the year to December 2005. Could this have something to do with the payment of benchmarking money to public servants?

Further, the annualised rates of inflation in the cost of “services” across the whole economy was about 6% in the first quarter of this year and rising. Could this have anything to do with our innate capacity for reaping super-profits when the opportunity presents itself? There is nothing to stop service providers from bumping up their prices in an economy where many consumers appear to regard high prices as an indicator of quality.

What are the implications for Ireland’s CPI if interest rates in Europe increase by a full percentage point in the coming period and not by the mooted half a point? What if energy prices go even higher because of tensions in Iran? For Ireland, there is the added uncertainty of the wage talks.

With inflation heading for 5% and the real economy growing by 6% a year, the trade unions will be looking for wage increases that are double the norm applied in recent wage deals.