Borrowing costs will go up – even if the Bank keeps rates at 0.5%

Another month, another shocking inflation figure.

In January, annual inflation (as measured by the consumer price index) clocked in at 4%. The Bank of England's target is 2%. If you use the retail price index (RPI), it came in at 5.1%. Both figures were in line with analysts' estimates, so at least they weren't any worse than expected. But it's hard to take much comfort in that. There's little sign that inflation will head lower any time soon, as all the inflation indicators that we watch suggest.

Surely the Bank of England (BoE) has to raise interest rates now? Well, we'll see. The inflation report is out tomorrow. That's where we'll get a view on Mervyn King and the team's latest thinking. And so far, Mr King in particular, has been reluctant to suggest rates will move any higher.

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Mr King points to all sorts of reasons why the current inflation is 'temporary'. And he's not keen to raise rates and squeeze the consumer even harder when much of the inflation is in the form of rising energy and food prices.

But there may be another reason for his reluctance, one he's not drawing quite so much attention to. And that's the fact that credit conditions are likely to get tighter over the next year, regardless of what happens with interest rates

Why Mervyn King doesn't want to raise interest rates

How does raising interest rates help to tackle inflation? Primarily by increasing borrowing costs. That makes spending less attractive, and saving more so. That cools the economy down demand falls. And falling demand makes it hard to sustain rising prices.

So you can perhaps see why Mervyn King doesn't really want to raise rates. Right now, inflation is already squeezing both consumers' pockets and corporate profits. If you have to spend more on petrol and basic food shopping, then you have less money to spend on other goods. If you then have higher borrowing costs so your monthly mortgage payment goes up too then that just makes life even harder.

This is not an inflationary boom that we're seeing. Prices aren't rising because the economy is too strong we're not China. This is, for want of a better word, stagflation. Weak growth, with rising prices.

Now, we're not saying this isn't dangerous. If inflation expectations pick up, there's every chance that the people who still have jobs will demand higher wages. And in those parts of the economy where capacity is tight, and the recovery is taking hold such as manufacturing this is already happening. This is why, if you want to know where rates are heading, one of the main indicators to watch is wage settlements.

However, whether you agree with him or not, you can see why Mr King is keen to put off raising rates for as long as he can. And there's another reason why the governor feels wary credit conditions are almost certain to get tighter this year, regardless of what the BoE does with interest rates.

Credit conditions likely to tighten over coming months

Why? Because as Vicky Redwood and Ed Stansfield of Capital Economics point out, the help that the banking sector has been getting from the BoE since the financial crisis kicked off, is being gradually withdrawn.

For a start there's the Special Liquidity Scheme. Under this, the BoE gave the banks nine-month Treasury bills in exchange for mortgage-backed securities and other rubbish that they were unable to sell, or use to borrow cash against. The banks were able to use these Treasury bills as "high quality collateral to raise cash in the markets".

By the end of this year, the banks are going to have to repay these loans. £110bn remains outstanding. In other words, they need to swap the nice, cheap source of funds that they got from the BoE for the harsh realities of the open market. The cost of this borrowing will be higher. And this, says Capital Economics: "is likely to feed directly into higher borrowing costs and reduced credit availability" for consumers.

There's also the Credit Guarantee Scheme. Under this, banks issued bonds with a government guarantee, "of which at least £110bn are still outstanding". This scheme is set to end next year. A third of the initial loans can be rolled over until April 2014, but the rest mature next April. In all if you include other outstanding debt set to mature the BoE reckons the big banks need to refinance about £400bn to £500bn by the end of 2012.

They can do this by raising more money from the likes of me and you using 'retail deposits' to close this 'funding gap.' However, as Capital Economics points out, "outstanding deposits would need to rise by some 40% from their current level of £1.2 trillion to solve the funding problem". That's not going to happen. So you might end up getting banks competing with each other for deposits in other words, offering better rates. That's good news for savers, but it will push up costs for borrowers.

The other option is to raise money in the wholesale markets. An over-reliance on wholesale funding is how Northern Rock came a cropper. And those markets shut down during the credit crunch. They've reopened but "the amount that banks need to refinance far outweighs the £130bn of term debt raised in the markets last year". So again, there's going to be a lot of competition for those funds, which means they'll be expensive.

All banks really do at the end of the day, is buy money from one group of people (depositors) and sell it to another (lenders). If the money costs the banks more to buy in, then they have to raise the price at which they sell it. So borrowing costs look likely to rise this year, regardless of what Mr King does with interest rates.

Sterling could be heading for a fall

There are plenty of implications, but a short-term one may be that the market has got ahead of itself in terms of rate expectations. If Mr King sticks to his dovish viewpoint at the inflation report tomorrow, sterling could be set for a fall. Of course trading currencies is risky but if it's something you're interested in, you should sign up for our free MoneyWeek Trader email. Veteran spread better John Burford shares tips and tactics for improving your spread betting odds.

By the way, John will also be appearing at The London Traders Expo on 8-9 April 2011, at the Queen Elizabeth II Conference Centre. Whether you're an experienced trader or just starting out, the exhibition gives you the chance to meet industry experts, test out the latest products and software, and pick up trading ideas and strategies. You can register free here.

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