So this is not the Great Depression. The economy is still struggling, house prices still falling and unemployment still rising, but the end of the world has been postponed. As I have argued for the past few months, and as the Bank of England confirmed in its quarterly Inflation Report yesterday, a rerun of the 1930s Depression or even a Japanese-style “lost decade” of stagnation is unlikely, even if economic prospects remain weak.

But as one horror recedes, another looms into view. With economic activity reviving, oil and gold prices rising and central banks printing money like wallpaper, many investors and economists, who only a month ago were panicking about a catastrophe of falling prices, are starting to believe that inflation will bring the sky falling down.

Assuming that signs of recovery continue, as the Bank of England clearly expects despite the Inflation Report's downbeat tone, Mervyn King could soon face pressure to start raising interest rates. Indeed some commentators believe that it is already too late - that by printing huge quantities of money the Bank has guaranteed an inflationary crisis in the years ahead.

As a result, many financial experts are advising borrowers to lock in to fixed-rate mortgages at relatively high interest rates to protect themselves against even higher rates to come. But are increases really inevitable? There are four reasons why the Bank could keep rates in the 0 to 2 per cent range for years ahead - and would be right to do so.

The first is the anti-inflationary impact of spare industrial capacity and unemployment. While unemployment is unlikely to reach the heights of the 1980s, the low level of inflation when this recession started means that wages will stagnate or even fall in the next two or three years.

Meanwhile, there is more excess capacity in most global industries today than at any time since the Second World War, suggesting that businesses will find it hard to put up prices. A few exceptional industries, notably oil, may organise global cartels to raise prices. But such supply inflation should be controlled by trying to break the Opec cartel with higher taxes on consumption rather than by raising interest rates to suppress global growth.

The second reason not to worry about inflation is the way that monetary policy operates. Inflation is caused, in layman's language, by “too much money chasing too few goods”. There will be no shortage of goods in the world economy for the foreseeable future, but if the Bank of England has created “too much money” couldn't inflation result? Yes, but there is no evidence that the expansion of Britain's money supply has gone too far.

While the amount of money created directly by the Bank has expanded by 64 per cent in the past year, this increase in “central bank money” has been largely negated by cuts in credit from private banks. As a result, the “broad money” used by non-financial businesses and households has grown only modestly since 2007.

Meanwhile, the amount of cash and bank deposits that people and businesses want as a protection against sudden changes in economic conditions or cutbacks in the availability of credit has greatly increased. With hindsight, it is clear that Britain has been too dependent on bank credit and that businesses, banks and households held too little ready money in relation to their economic activity and wealth.

To take the simplest example, people who stop using credit cards will need more cash in their daily lives. At a more sophisticated level, banks acknowledge that they should have held a far bigger proportion of assets in cash and Bank of England reserves. If regulators make them do this in the future, the amount of money supplied by the Bank will have to be increased dramatically. So if we assume that many of the changes in financial behaviour that have occurred recently will continue, the Bank will have to provide much more money than it did two years ago to support any given level of economic growth. Consequently, it is far from clear that it should withdraw any of the £125 billion of new money it has created since the start of the credit crunch.

The third reason is connected with the Government's borrowing binge. With public borrowing now running at unsustainable levels, both the Treasury and the Bank of England see reducing government deficits as the priority after the recession. To do this, the Government will have to raise taxes and cut public spending, both of which will curb growth and deflate the economy.

Once the economy recovers enough to withstand some government austerity, it will be much healthier for the tightening to be administered though smaller budget deficits than higher interest rates. But if taxes are raised and spending cut aggressively after the general election, which is both possible and desirable, the Bank would have to be cautious about raising interest rates at the same time. Doing both could tip the economy back into recession. This is a lesson from Japan that Bank officials thoroughly understand. In 1997, after a year of strong recovery, Japan simultaneously raised taxes and reduced the growth of its money supply. The result was a public deficit that expanded, instead of shrinking, as Japan relapsed into recession.

Which brings me to the final reason to expect low interest rates for many years ahead. It is assumed that if British households and businesses decide to save more and cut back on borrowing, the result will be lower growth. But more saving and less borrowing should actually increase long-term growth.

Why then does almost everyone assume that Britain's growth will be slower in the years ahead? Because conventional wisdom confuses supply and demand. If households increase their savings (whether by putting money into their bank accounts, increasing their pension payments or buying shares), this reduces their demand for goods. But assuming that those extra savings don't sit idly, but are lent to businesses that want to expand, supply of goods in the economy will increase.

How is this divergence between supply and demand reconciled? This is where monetary policy comes in. An economy in which the savings propensity has risen permanently will need lower interest rates than in the past. Only by keeping rates low by historic standards, will demand and supply be kept in balance and full employment be maintained. Making sure that demand grows in line with productive capacity is now the main task for British monetary policy - and will be in the years ahead.

Times Recommends

• Copenhagen will fail – and quite right too
• They’re still wriggling to avoid the flak on Iraq
• Rule the waves? Not any more we don’t