Bad things happen when people don’t pay their credit card bill.
Here’s how the “logic” works: Charge-off’s increase and banks aren’t going to eat it all themselves. They raise interest rates on cards they issued and increase merchant fees to cover the losses. Merchants respond by raising prices to cover their increased fees, and consumers see a loss in available credit as the additional interest eats into their available credit (for those that carry balances and fail to make payments that cover interest plus at least some principal, apparently a lot of people). So we have price increases without corresponding demand increases = inflation.
BUT, inflation only happens if people keep buying in the wake of price increases. With consumer confidence weak, people may just put off buying or be unable to buy because they are capped out on their credit cards. So the buying stops, the prices go flat, and (good news) the charge-off rate declines simply because there is less activity.
By then it is November, and merchants are desperate to see shoppers in the store for holiday buying. So they slash prices; but it doesn’t work, because the card issuers still have credit card interest rates pegged and haven’t unlocked larger credit limits. Why should the credit card issuers expose themselves to more risk? They are making money on the high interest and have lowered expectations from Wall Street on their side.
There is a catch in this “logic”; the economic term ‘deflation’ only applies if the decrease occurs for at least a year (aka 0% inflation over 12 months). More specifically:
“Deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity.” (Wikipedia)
So what happens next? You ask a Scandinavian.
“If the nominal interest rate is initially low, which it is when inflation and expected future inflation are low, the central bank does not have much room to lower the interest rate further. But with deflation and expectations of deflation, even a nominal interest rate of zero percent can result in a substantially positive real interest rate that is higher than the level required to stimulate the economy out of recession and deflation.” (Svensson, 2003)
This in turn leads to the Liquidity Trap:
“When this liquidity trap occurs, expanding liquidity (the monetary base) beyond the satiation point has no effect. If a combination of a liquidity trap and deflation causes the real interest rate to remain too high, the economy may sink further into a prolonged recession and deflation.” (Svensson, 2003)
Sounds bad, but has it already happened, or is it in the future:
“Prolonged deflation can have severe negative consequences. The real value of nominal debt rises, which may cause bankruptcies for indebted firms and households and a fall in asset prices. Commercial banks’ balance sheets deteriorate when collateral loses value and loans turn bad, and financial instability may threaten. Unemployment may rise, and if nominal wages are rigid downwards, deflation means that real wages do not fall but increase, further increasing unemployment. All this may contribute to a further fall in aggregate demand, a further increase in deflation, a further increase in the real interest rate, and bring prices and the economy down in a deflationary spiral. Therefore, a liquidity trap with the associated risk of a prolonged recession or even a deflationary spiral is a central banker’s nightmare.”
(Svensson, 2003)
Reference:
Svensson, 2003 – http://www.princeton.edu/svensson/papers/jep2.pdf
Bad things happen when people don’t pay their credit card bill.
Here’s how the “logic” works: Charge-off’s increase and banks aren’t going to eat it all themselves. They raise interest rates on cards they issued and increase merchant fees to cover the losses. Merchants respond by raising prices to cover their increased fees, and consumers see a loss in available credit as the additional interest eats into their available credit (for those that carry balances and fail to make payments that cover interest plus at least some principal, apparently a lot of people). So we have price increases without corresponding demand increases = inflation.
BUT, inflation only happens if people keep buying in the wake of price increases. With consumer confidence weak, people may just put off buying or be unable to buy because they are capped out on their credit cards. So the buying stops, the prices go flat, and (good news) the charge-off rate declines simply because there is less activity.
By then it is November, and merchants are desperate to see shoppers in the store for holiday buying. So they slash prices; but it doesn’t work, because the card issuers still have credit card interest rates pegged and haven’t unlocked larger credit limits. Why should the credit card issuers expose themselves to more risk? They are making money on the high interest and have lowered expectations from Wall Street on their side.
There is a catch in this “logic”; the economic term ‘deflation’ only applies if the decrease occurs for at least a year (aka 0% inflation over 12 months). More specifically:
“Deflation is caused by a shift in the supply and demand curve for goods and interest, particularly a fall in the aggregate level of demand. That is, there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity.” (Wikipedia)
So what happens next? You ask a Scandinavian.
“If the nominal interest rate is initially low, which it is when inflation and expected future inflation are low, the central bank does not have much room to lower the interest rate further. But with deflation and expectations of deflation, even a nominal interest rate of zero percent can result in a substantially positive real interest rate that is higher than the level required to stimulate the economy out of recession and deflation.” (Svensson, 2003)
This in turn leads to the Liquidity Trap:
“When this liquidity trap occurs, expanding liquidity (the monetary base) beyond the satiation point has no effect. If a combination of a liquidity trap and deflation causes the real interest rate to remain too high, the economy may sink further into a prolonged recession and deflation.” (Svensson, 2003)
Sounds bad, but has it already happened, or is it in the future:
“Prolonged deflation can have severe negative consequences. The real value of nominal debt rises, which may cause bankruptcies for indebted firms and households and a fall in asset prices. Commercial banks’ balance sheets deteriorate when collateral loses value and loans turn bad, and financial instability may threaten. Unemployment may rise, and if nominal wages are rigid downwards, deflation means that real wages do not fall but increase, further increasing unemployment. All this may contribute to a further fall in aggregate demand, a further increase in deflation, a further increase in the real interest rate, and bring prices and the economy down in a deflationary spiral. Therefore, a liquidity trap with the associated risk of a prolonged recession or even a deflationary spiral is a central banker’s nightmare.”
(Svensson, 2003)
Reference:
Svensson, 2003 – http://www.princeton.edu/svensson/papers/jep2.pdf
