We'll still bop until house prices drop

The governor of the Bank of England normally cuts a pretty relaxed figure. Mervyn King's performances in explaining decisions on interest rates resemble that of a laconic Clint Eastwood arriving in a gun-toting town in the Wild West.

So was it a case of 'make my day' when, as he presented last week's Inflation Report, King warned of 'a risk that some heavily indebted households will be badly affected by changes in economic circumstances or interest rates'? Or was it an unusually candid hint of higher rates to come?

Some clues came in the question and answer session after the presentation. The Governor appeared far more chilled out about the nation's debt perils, pointing out that the economy is a long way from the problems of the early 1990s housing crash.

'The scale of the problem seems much less and is likely to be much less, even if there were to be a fall in house prices, than it was a decade ago. The picture of indebtedness for all households taken together is by no means as bad as some of the headlines might suggest,' he said.

The most common measure of indebtedness is flashing red. Average house prices now exceed five times Britain's average household disposable income, greater than the ratio at the peak of the early 1990s boom. In the past year a buoyant housing market has seen the growth in debt secured against a property shoot up to 14 per cent. That is the bad news.

But the Bank believes you have to look at both sides of a household's balance sheet. Debt may have risen rapidly, but so has the value of assets. The Bank focuses on something called net worth, which essentially subtracts the value of household assets from its debts. Net worth has been flat over the past year, another way of saying that debts have grown only in line with house prices. Another slice of good news is that low interest rates have kept monthly mortgage costs roughly stable over the last decade, despite a huge growth in the stock of debt. Mortgage arrears and repossessions have been falling and are low historically, 'suggesting that households have been able to service their debts without too much difficulty', says the Bank in its Inflation Report. Such statistics may well have made the day of most homeowners, but it is clear that the good times only last as long as the value of property assets continues to rise.

And then there are the downsides to all of this, in a particularly worrying paragraph of the report. 'It is not clear that rises in house prices should cause households to be wealthier in aggregate. Households that are yet to buy homes, or who wish to buy more expensive homes, face a higher prospective cost of living.'

But surely that's a little Micawberish. Haven't plenty of Britons made a killing on the housing market?

'Some households, particularly in older generations, have made large windfall gains. But they may not be better off if they feel obliged to make larger gifts or bequests to compensate their children for higher costs of housing,' says the report. Then it gets a bit scarier: 'The value of financial and housing wealth is inherently uncertain - prices can change. But debt is not subject to revaluation in the same way.'

Look at the bottom chart on the left. Repossessions and arrears are declining and at lows. But personal bankruptcies have shot up. approaching early Nineties' levels. The Bank puts this down to credit card and other unsecured borrowing by low-income families. It is also worth noting that in the two years before the housing crash and record surge in repossessions and arrears, both measures were falling too.

So what does this mean for interest rates? The consensus among economists and the City is that this month's rate hike was part of a minor nudge up. The markets think it is part of a gradual tightening that will see rates at 5 per cent by the end of next year.

HSBC economist John Butler has argued that such high levels of debt may hold back any inclination to hike rates too high. Some isolated City economists think the Bank will be cutting again by the end of next year.

But the Bank's highly technical charts suggest the very opposite. The key is the difference between two so-called 'fancharts' of future inflation. One assumes that interest rates are kept on hold at 3.75 per cent. The other assumes that rates will be hiked to 5 per cent over the next year. Yet the difference between the two charts' expectations for inflation is negligible - just 0.1 per cent.

'The forecasts in the Inflation Report just don't add up. In the past a similar difference [in rates] between these two charts has seen a difference in expected inflation of 0.4 per cent. Is the Bank now saying that interest rate rises are irrelevant to inflation?' asks HSBC's Butler.

Butler suggests that the Bank's new forecasting model may be showing that rates are less important. Either way, he says, these minor changes add up to a new era in Bank policymaking, specifically in the manner in which it communicates with markets. 'Communication used to be about analysis, but now it's about words, hints and speeches. It's a conscious decision to move towards the US system of short-term market management and less attention to actual inflation report analysis,' says Butler.

There may be a quiet revolution going on at the Old Lady of Threadneedle street. It is likely to proceed slowly, but could explain last week's mixed messages.

As King said on the subject of household borrowing last week: 'We never set out to scare people or indeed to make threats.' He may need to take the same approach with the markets.