Two events last week will set the course of the British economy for years to come. Both these momentous events — the pound bursting through the $2 barrier and the consumer price index breaking out of the margin for error allowed around the Bank of England’s inflation target — occurred on Tuesday morning and this was not just coincidental.

The strength of the pound and the sudden inflation upsurge were closely connected, although in several contradictory ways. The jump in inflation made further interest-rate increases by the Bank of England inevitable and therefore increased the relative attractiveness of the pound, at least in the short term. At the same time, however, the rise in sterling should intensify the competitive pressure on British industry and push down import prices, thereby helping to check inflation.

That is a benign view of last week’s events, but a much less rosy scenario can be presented. The fact is that strength of sterling should already have reduced prices in Britain and therefore suggests that underlying inflationary pressures are much stronger than the Bank of England and the markets expected. To make matters worse, accelerating inflation makes sterling less attractive in the long term and raises the possibility that Gordon Brown and the Bank have “totally lost the plot” in their efforts to manage the British economy, as one leading international investor put it.

If this view were to become prevalent among investors, the pound could quickly start to fall instead of rise, sending inflation much higher and demanding a much harsher monetary squeeze than anything seen in Britain since 1992.

Right now, this scary possibility still seems farfetched, but everything depends on the actions of the Bank and the currency markets. The Monetary Policy Committee is virtually guaranteed to raise interest rates at its next meeting, on May 10, but there could be a strong case for the Bank to show that it means business by lifting the base rate by half a point to 5.75 per cent, instead of just moving by the traditional quarter-point. Such a drastic move might well be resisted by some members of the MPC, as a sign of panic or an admission that they had been caught napping by the upsurge of inflation. In reality, however, it would emphasise the seriousness of their commitment to control inflation, as well as the pragmatism and flexibility, of which the Bank has been justifiably proud.

Mervyn King has always emphasised that the Bank’s objective is not just to keep inflation a hair’s breadth below the 3 per cent “ceiling”, but to get it all the way down to the 2 per cent official target as quickly as possible — and then keep it there.

If this is really the Bank’s objective (and the law says it should be), then there is an overwhelming case for a half-point rate hike next month. The economy is growing rapidly, world commodity prices are soaring, the property market is still overheated and British businesses feel remarkable freedom to raise their prices. Worst of all, the official inflation figures are widely disbelieved, with a widespread view that the old retail prices index, which is rising by 4.8 per cent, represents inflation more accurately than the CPI. So if Mr King is serious about curbing inflationary expectations, a hint of panic might be in order.

What, then, are the arguments against drastic action? I can think of only one. The pound is now testing the $2 barrier that has limited its upside since 1990. If it breaks decisively through this ceiling, it could quickly move much higher, perhaps even into the trading range of $2.20 to $2.50 that it occupied for most of the 1970s and early 1980s.

For British exporters, a currency surge such as this would be very painful and many would doubtless blame the Bank for their misfortunes if it raised interest rates by half a point or more in the next few months.

Such whingeing would almost certainly be wrong. What happens to sterling in the near future will depend much less on monetary actions in Britain than on events in Europe and the US. If the euro continues to rise against the dollar, then the pound will almost certainly break through $2 and quite possibly head for much higher levels like $2.20 or even $2.50. If, on the other hand, the euro retreats at its 2004 peak of $1.3650, which it is currently testing, then sterling is also likely to fall back, regardless of how far British interest rates rise.

The fact is that sterling’s turning points against the dollar have always been very closely correlated with those of the euro (and before that the Deutschemark). This has been true at buying climaxes (for the pound and euro) in 1980, 1990, 1992 and 2004, as well as at selling climaxes in 1976, 1985, 1994 and 2001/2.

Whether sterling’s present assault on the $2 barrier goes down in history as another such historic turning point will depend mainly on whether the euro can breach its 2004 record high. This, in turn, will depend mainly on whether the US economy languishes and Fed eases monetary policy, while Europe continues to boom and the ECB continues to raise interest rates, as most investors currently expect. In my view, both these assumptions are improbable — and if I were right the euro probably would fail to break through the record high it is now testing and the pound would probably reverse as well, regardless of what the Bank might or might not do. The trouble is, of course, that the markets do not agree with me.

Thus there is a serious risk of sterling overshooting and the Bank would probably be blamed for this if it raised interest rates more aggressively than expected.

This, however, is a risk that the Bank should be willing to take. Mervyn King knows as well as King Canute that he cannot control the tides in the foreign exchange markets. Meanwhile, he has a clear duty to control the present inflationary upsurge — and all the tools he needs to do the job done. If he acts quickly, Mr King can expect universal public backing for whatever action is needed to tame inflation. The national consensus against any return to the inflationary nightmares of the 1970s and 1980s is overwhelming — and Gordon Brown understands this better than anyone else. The Bank thus enjoys ideal conditions to show that it can do its job. But it cannot afford to fail. Any central banker who can be blamed for reigniting inflation in today’s Britain, will be seen as guiltier of high treason than Guy Fawkes.

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive