The six degrees of Mervyn King

You may be wondering why on a day when the Bank of England’s governor, Mervyn King,  announced that Britain’s consumer price inflation rate rose to 3.5% that I chose a headline regarding soaring credit card interest rates as the Headline of the Day.

This is in part due to the increase in inflation being expected, as a result of the Bank of England Inflation report (see previous post), but mainly to illustrate how two separate articles which seem unrelated are in fact relevant to one another. Further more when looked at together they might hint at future issues facing the economy.

Starting with the Headline of the Day. To sum up:

• More and more people are defaulting on their credit card debt
• Rates are going up as a result so making borrowing more and more expensive
• Credit is becoming increasingly more difficult to come by for consumers as lending criteria is tightened.

Now the inflation story……..

Again to sum up:

• Inflation has jumped up and now sits outside of the government’s  2% target.
• This is partly down to the recent restoration of the VAT rate to 17.5%  - plus higher oil prices and the depreciation of the pound
• Mervyn King expects inflation to drop back later in  the year largely due to the way the inflation figure is calculated.

Although the Bank of England’s forecasts have been reasonably accurate historically let us assume that inflation does not fall back. If that is the case then the Monetary Policy Committee (MPC) may have to resort to one of its only weapons to combat inflation. Which is to increase interest rates.

In very simplistic terms, increasing interest rates would make credit more expensive which would dampen consumer spending. This would reduce demand for goods and services and result as a result prices (inflation) would likely decline. So achieving their aim.

But an increase in the bank base rate would mean that people’s mortgages payments would go up (those who are not on fixed deals anyway). The current historically low bank base rate means that some people are paying next to nothing to own their house. For some this has managed to keep the wolf from the door. But, if rates rise so will people’s monthly mortgage bills and people who are living on the bread line will not be able to meet their obligations.

What usually happens is that people will borrow at all costs to keep a roof over their family’s heads. This gives rise to people using their credit cards to pay their mortgages, even though they have no way of paying their bill at the end of the month. According to a recent survey by Shelter there are over a million houses in this desperate situation. It is no surprise then that Housing Minister John Healey recently stated that ‘’repossessions are running at half the rate of the last recession ‘’. The problem is simply being  masked and is building up in the background. But as shown by my Headline of the Day on the 11th Feb 2010 repossessions have still reached a 14 year high.

Now if we bring in the headline regarding the increases in credit card interest rates and tightening lending criteria – you can see that some of those 1million households might soon be hitting the buffers as one of their means of holding off the bank is drying up. If the Bank of England don’t keep a lid on inflation then its likely that it's not a might soon but how many will hit the buffers. Increased interest rates and therefore mortgages payments will increase the pressure on households at the same time as a possible pressure release valve is cut off. If credit card companies were continuing to lend freely and cheaply then some households may be able to survive long enough until they are able to rectify their cash flow problem. The end result of this increased pressure on households is a rise in repossessions which could dampen any economic recovery.

While the above scenario is one of many possibilities it highlights both how complex the economy is but also how the cost of /access to credit is pivotal to any economy, including its booms and busts.