Yesterday's inflation figures confirm the prognosis beyond all doubt, with now strongly rising inflation even as the housing market and wider economy nosedive. There could hardly be a worse combination, with fast rising prices severely limiting the Bank of England's scope for interest rate cuts to deal with the rapidly slowing economy.

Mervyn King, Governor of the Bank of England, discourages use of the word "stagflation" to describe what are plainly not yet distress economic conditions. Compared to the 1970s, when the term first came into use with double-digit rates of inflation in combination with outright recession, today's economic difficulties still seem relatively contained. Perhaps the Governor would prefer the more fashionable City labels of "slowflation" or "slugflation".

Even so, there is now obviously a quite high risk of things getting a great deal worse, witness yesterday's hilarious spectacle of Caroline Flint, the luckless minister for housing, marching into a Cabinet meeting carelessly displaying a briefing document showing the Government's "at best" assessment of a 5-10 per cent fall in house prices this year.

The Government, it seems, reserves discussion of the reality of what is going on to private Cabinet meetings, while for public consumption it continues to peddle a diet of unremitting optimism and complacency. Only last week Ms Flint said that the fundamentals of the UK housing market remained strong.

As if to underline the Government's apparent inability to keep up with events, it plans tomorrow to announce a package of measures to help first-time buyers. Should ministers really be encouraging anyone, let alone first-timers, to buy in a falling market? I don't think so. They might even be done for mis-selling.

Key elements of Government economic policy seem to be unravelling at worrying speed with the return of these less benign conditions. There is nothing like a slowdown to challenge accepted thinking and established norms. After yesterday's shock inflation news, the debate must extend to the inflation target, set by the Government but independently pursued by the Bank of England.

These arrangements were until recently widely regarded as a triumph of economic policy making, yet, like all targets which when set seem like a thoroughly good idea, the inflation target may, at least in its present form, have outlived its usefulness, another apparent victim of "Goodhart's law".

This is the theory named after the economist Charles Goodhart, which states that once an economic indicator is made a target of public policy it becomes increasingly devalued and eventually irrelevant or even counter-productive.

In one of his earliest speeches as Governor of the Bank of England, Mr King committed the Bank in an act of almost religious devotion to controlling inflation within the parameters set by the Government, and said that the Bank would only have itself to blame if it failed.

Yet what does the Bank do when the main inflationary or disinflationary forces in the economy are coming not from these shores but from the rest of the world, which by definition lies outside the Bank's control?

Nobody would thank the Bank for raising interest rates to deal with an inflationary threat which comes largely from imported oil and food prices if the effect is to plunge the economy into recession. Even in the good times, the inflation target worked in a way which with the benefit of hindsight may have been inappropriate. As Asia industrialised and Europe expanded, it brought the benefits of an apparently limitless supply of cheap labour to the price of goods and services.

This disinflationary effect allowed the Bank to stay close to the inflationary target even with comparatively lax monetary policy, which in turn helped stoke the credit and housing bubbles.

Now the tables are reversed, with strongly growing domestic demand in emerging markets leading to unprecedented competition for limited resources and consequent, fast rising, inflation. Inflation may seem bad here, but in India it is at 7.5 per cent, in China at 8.5 per cent, in Vietnam at 21 per cent and in Sri Lanka at 25 per cent. In Brazil, too, inflation is strongly on the rise, despite the counter-inflationary effect of a rising currency.

These global trends are affecting inflation here in the UK in a manner the Bank of England looks powerless to contain. What's more, the Bank is also quite plainly losing control of inflationary expectations. Rightly or wrongly, everyone thinks prices are rising much more steeply than the targeted measure – the Consumer Prices Index – suggests.

Up to a point, they are right about this. As disposable incomes become squeezed, people are increasingly forced to limit their spending to essentials – food, energy and housing. These are the very items that are inflating most acutely. As spending shifts from discretionary to non-discretionary, so too does the general population's experience of inflation get worse.

Central bankers sometimes like to refer to "core inflation", that is inflation excluding all the things they cannot control such as fuel and food prices. The irony of the term is that the items left out are precisely the ones most people would regard as core to their inflationary experience.

As for the things that have been going down in price – occasional purchases such as cars, flat-screen TVs, computers, cameras and so on – you have to wonder how much longer it will last, what with the weak pound and growing demand for consumer durables in the developing world. It's not yet stagflation, which implies a return to the 1970s, but it is certainly not looking pretty either.

In the US, the Federal Reserve has no formal inflation target. Instead, there is discretion to allow higher inflation in defence of jobs and growth. That may not be an option for Britain, a much smaller economy without the reserve currency advantages of the US dollar.

But both during the boom and now the downswing, narrow targeting of the CPI has been found wanting. The debate already raging in the wake of the credit crunch over whether monetary policy should be obliged to take account of the credit cycle needs to be extended into wider consideration of the merits of narrow inflation targeting.

Globalisation of the world economy has already caused the Bank of England to lose control of interest rates. Now it is in danger of losing control of inflation too.

Chancellor delivers a Keynesian boost

Ken Clarke, the last Tory Chancellor, once said he soon lost interest in that chronic obsession of Chancellors – tax reform – after realising that, whatever you did, there would always be winners and losers, and that you would be blamed by the losers while being given no credit whatsoever by the winners.

Alistair Darling, the present incumbent, has been forced to learn Mr Clarke's wisdom the hard way. Yesterday's package of measures to address the political damage done by the abolition of the 10p income tax rate still leaves 1 million losers, and that's before anything the Chancellor does next year to get the tax giveaway back.

Yet there is also a thinly disguised economic purpose in the climbdown. The £2.7bn cost of raising tax allowances for basic-rate taxpayers is a big sum of money which will have a pronounced reflationary effect at a time when the economy certainly needs it.

There's no comparison with the $156bn of tax rebates being pushed through by the Bush administration in the US, but it is a similar sort of thing which, because it specifically benefits the lower paid, will be doubly pleasing to Labour loyalists.

This is of course money the Chancellor doesn't have. We'll have to wait to see how and when he intends to claw it back. Or maybe he's taken the view that the public finances are already such a busted flush that it's not worth worrying about any more.

With angry voters to face in next week's Crewe by-election, the Government's reputation for prudent management of the public finances has been sacrificed to political expediency.