UK Household balance sheets and inflation

The Raven chose his lunch break yesterday as an opportunity for mastication of the proverbial cud. He chose to reread the weekend's Economist in a state more awake and alert than he had been on Saturday morning, sans coffee. The Economics Focus section had a couple of comments which he disagrees with, but had blithely slipped under his radar;



"Spending in rich countris, such as America and Britain, will flounder as long as householdslook to pay down debts they aquired to buy expensive homes. A burst of inflation would speed up this process by eroding the real value of mortgages".



Well this may well be true in the US, but the Raven takes issue with applying the same logic in the UK. In the US its pretty normal to take out a fixed rate mortgage, whereas in the UK its a small percentage of people that fix and when they do its usually for 2yrs or less. Therefore this glib statement that inflation and the associated higher interest rates would be beneficial to UK household balance sheets is not only wrong, but dangerously lazy in its thinking.



Lets look at the effect on the 'average' or more precisely median household in the UK of inflation of the 1970s style.



HBOS survey "average houseprice" of £160k.

median household income of £30k.

current floating mortgage rate of 5% for a first time buyer with LTV of 90%.

so mortgage payments of £8k a year, approx 26% of gross income. lets say inflation is 10% for one year, and lets say our first time homeowners are especially skilled at wage negociations, they manage a 5% real wage increase so that their household income is £34.5k (+15% gross). But lets also be kill joys and say that perhaps the BoE acts and raises interest rates to 8% (only!), so mortgage rates go to 12%, which would then make the mortgage payments £19k, 55% of gross wages. You don't have to be a genius to see that consumer spending would get shafted and house prices would be smashed by a wave of foreclosures and reposessions. In fact at that point one would imagine that house prices would face a really serious fall, and a proper buyers strike, and unfortunately that would be the same time that a lot of home owners would be locking in their exposure to houseprices, because after they've been forced to sell if prices rise they're not going to be participating.

Its not like the Raven has been dramatic with his assumptions there, what happens if the worker only got inline with inflation wage rises? and if the BoE had to raise rates the same amount? then we're talking £33k, and mortgage payments of £23.5k, so approx 71% of gross income. Now that is negative convexity and something that could destroy households in the UK.

Yet its something that has happened in living memory and very very few households would be prepared for. So perhaps readers can see why the Raven thinks that the commentary from the economist this weekend is a liiiiiiitle dangerous.

at 17% inflation it doesn't matter what a household in the UK does, they are broke. Yet most households would take that risk, and for what gain a 1% or 2% difference in their mortgage payments? speculation indeed...