The Reserve Bank’s latest cut to the official cash rate has made it look for once like Santa Claus instead of the more familiar Grinch who stole Christmas.

Essentially the bank has thrown in the towel on fighting inflation, as have other central banks in countries afflicted by the credit crunch.

The gamble being taken is that a slowdown in the real economy is going to nobble stubborn inflationary pressures, allowing monetary policy to ease off from its inflation-fighting role.

One of the global vectors of inflation, commodity prices, has already co-operatively knuckled under as demand destruction in the real economy has caused commodity prices to drop like a stone.

Accordingly, we see some peculiar relationships between policy interest rates and inflation rates at present.

The Reserve Bank reports that the OCR stands at 5%, whereas annualised inflation to September, as measured by the CPI, was running at 5.1%.

The Reserve Bank of Australia, which on Monday cut its overnight target cash rate to 4.25%, says Australia’s annualised CPI in September was 5%.

The Bank of England’s statistics show that its current bank rate is 2%, whereas current inflation is 4.5%.

The US Federal Reserve has the federal funds rate down at 1%, with many expecting the rate to fall to 0.5% soon, whereas its October Federal Open Markets Committee (FOMC) minutes recorded projected personal consumption expenditure (PCE) inflation as running within a range of 2.7% to 3.6% for 2008.

In other words, central banks are running negative real interest rate regimes, in that inflation rates are in excess of policy interest rates.

The Reserve Bank joined this club with yesterday’s cut.

If it continues to cut the OCR as many expect, then the negative real interest rate phenomenon will become more exaggerated in New Zealand.

When real interest rates are negative, lenders are subsidising borrowers and clearly this cannot continue indefinitely.

At some point the largesse of central banks will need to be withdrawn, and interest rates reset to more normal relationships versus inflation.

How high interest rates will need to rise will depend on how far down inflation subsides as the credit crunch knocks the stuffing out of the real economy.

The FOMC’s October minutes show expected US inflation on the PCE measure tracking at 1% to 2.2% over 2009, 1.1% to 1.9% over 2010, and 0.8% to 1.8% over 2011.

In other words, the Fed is picking that US inflation is going to track down steadily over the next three years.

This view may be overly optimistic, as central banks are creating a liquidity bubble by slashing policy rates and printing money as they struggle to keep the near comatose commercial banking system surviving on life support.

The immediate risk to avoid is of course another Great Depression, and that means central banks have to ensure that enough of the commercial banking system lives on to fight another day after intensive rehabilitation therapy.

The big risk sitting a bit further out in the future is a return to strongly rising inflation, a risk which will force the hands of central banks.

To forestall what is already a mounting threat of higher expected inflation, central banks will have to start clicking up policy rates again, and perhaps not before too long.

The OECD, in its latest biannual Economic Outlook report (Number 84), is picking that major central banks like the US Fed, the Bank of England and the European Central Bank will have to start moving interest rates up to more normal levels from the fourth quarter of 2009.

In other words, supposing the OECD is correct, policy interest rates will be headed back up again in just a year from now.

In light of this prospective turnaround in interest rate settings, which our inflation-shy Reserve Bank is likely to copycat, the next few months might be a good time for borrowers to consider locking in long-term fixed mortgage rates, and for lenders to think about sticking to short-dated term deposits.