Perhaps the real reason interest rates in Australia are going up, and will keep doing so, is the current account deficit, not inflation.

Australia’s current account deficit is around 6 per cent of GDP despite the highest terms of trade in 50 years (that is the highest export prices relative to import prices).

This is due to Australia’s spendthrift households, and their spending has been financed largely by foreign debt, much of it supplied by structured finance markets in the US that have now closed.

Household debt has increased from 70 per cent of income at the end of the last recession in 1991 to 200 per cent of income today. At the same time, the national foreign debt has increased from 75 per cent of GDP to 150 per cent.

The western world has entered its first genuine credit squeeze for decades, as banks attempt to rebuild their shattered balance sheets. It’s not rising official global interest rates that are driving up the cost of borrowing, it’s that the supply of credit has dried up as banks throttle their lending as the markets for commercial paper simply shut down.

US banks have already written off $US125 billion in sub-prime related loan losses. Because of the way banks are geared, multiply that by 12 for the effect on lending capacity (it’s a $US1.5 trillion hole in lending capacity).

The general consensus appears to be that write-offs will end up totalling $US400 billion. That would mean a cutback in credit availability of nearly $US5 trillion.

Meanwhile in Australia, offshore demand for Australian paper has already fallen and interest rates have been rising to attract investors and lenders.

Bank deposits are rising as the public appetite for investment risk declines, but Australia’s banks are also starting to have to watch their capital. There is no prospect here of the sort of write-offs seen among US banks, but ANZ certainly shocked investors with its $200 million provision against potential monoline-insured loan losses.

And as the national economy slows in response to tighter monetary policy, the impact across the nation will be disproportionate: the resources states – WA and Queensland – will be supported by mineral and energy exports, while Victoria and NSW will be hit relatively harder.

That might mean that the banks’ provisioning might have to quickly rise to accommodate deeper problems in those eastern and southern states, which would also cause lending capacity to be throttled back

Meanwhile, the Reserve Bank is taking it one rate hike at a time.

Having raised rates 10 times in a row in six months, including by nearly 1 per cent in six month, the RBA is now forecasting that inflation will now rise a bit more and then fall to 3 per cent.

Apparently another rate hike in March is a lock (the futures market has odds on that of 93 per cent), so as Rory Robertson pointed out yesterday, it’s the biggest shock to homeowners since Bernie Fraser raised the cash rate by 2.75 per cent in four months in late 1994.

Although the market is predicting two, perhaps three, more official rate increases in Australia, it is much more likely in my view that the international credit squeeze coupled with Australia’s current account deficit and high level of household debt will do the bank’s job for it and bring the economy to a screeching halt later this year.

The RBA is now predicting a strongish economy and high inflation out to 2010. Last year it was predicting that inflation would fall by now, which was wrong.

There’s no reason to think it’s right now.