The Daily Reckoning
London, England
Wednesday, September 13, 2006
The Daily Reckoning PRESENTS: Wall Street and investors can only be so
optimistic, due to an almost universal expectation that the Federal
Reserve has definitely stopped its rate hikes. This, essentially, assumes
that further rate hikes were the greatest imminent risk to the economy and
the markets - bonds, stocks and housing. The Good Doctor explores...A TIGHTENING FARCEby Dr. Kurt Richebächer
There is total detachment from the bad news that is pouring out of the
economy. For several years, the booming housing market has made the
difference between recession and recovery for the U.S. economy. Zooming
house valuations provided private households with the collateral that
allowed them to replace the missing income growth with a borrowing binge.
But as the housing market is sagging, this major source of higher consumer
spending is plainly drying up, and most obviously and importantly, income
growth is by no means catching up.
In 2005, real disposable incomes of private households in the United
States increased $93.8 billion, or 1.2%, while their debts grew $1,208.6
billion, or 11.7%. Total consumer spending on goods, services and new
housing accounted for 92% of real GDP growth.
The U.S. economy's recovery from the recession in 2001 has been its
slowest in the whole postwar period, and in addition, it has been of a
most unusual pattern. Real GDP rose by 11.7% over the four years to 2005.
Within this aggregate, residential building soared by 35.6%. Consumption
gained 13.4% and government spending 10%. The big laggard in domestic
spending was business nonresidential investment, up only 3.6%. Net exports
year for year were increasingly negative.
Most economic data have softened, with the downtrend accelerating. In the
face of this fact, it could not be doubted that Mr. Ben Bernanke and most
others in the Federal Reserve were anxious to stop their rate hikes. In
question was only whether they would dare to do so in view of the high and
rising inflation rates. They dared. They even disappointed those who had
predicted the combination of a declared "pause" with hawkish remarks about
fighting inflation.
In its statement, the Fed conceded:
"Readings on core inflation have been elevated in recent months, and the
high levels of resource allocation and of the prices of energy and other
commodities have the potential to sustain inflation pressures. However,
inflation pressures seem likely to moderate over time, reflecting
contained inflation expectations and the cumulative of monetary actions
and other factors restraining aggregate demand."
When the Bureau of Labor Statistics (BLS) reported on Aug. 16 that the CPI
in July had seasonally adjusted, advancing 0.4%, following a 2% rise in
June, both the bond and stock markets responded with strong rallies. What,
apparently, had made it so exciting in the eyes of the consensus was the
fact that these bad figures had remained in line with distinctly
unoptimistic predictions. Never mind that during the first seven months of
2006 the CPI has risen at a 4.8% seasonally adjusted annual rate, compared
with an increase of 3.4% for all of 2005.
It is, of course, perfectly true that monetary tightening impacts the
economy and its inflation rates with a pretty long delay. The trouble in
the U.S. case is that there never was any monetary tightening. There were
many small rate hikes, and the Greenspan Fed had probably hoped that the
higher costs of borrowing would exert some restraint on credit demand. But
it has not happened. It was a vain hope.
The fact is that the credit expansion has sharply accelerated during these
two years of rate hikes instead of decelerating. During 2004, when the Fed
started its rate hike cycle, total credit, financial and nonfinancial,
expanded by $2,800.8 billion. In the first quarter of 2006, it expanded at
an annual rate of $4,392.8 billion.
Over the two years of so-called monetary tightening, the flow of new
credit has effectively accelerated by 56%. In 2005, credit growth was
$3,335.9 billion. Over the whole period of rate hikes, it had steadily
accelerated from quarter to quarter. Borrowers and lenders, apparently,
simply adjusted to the higher rates, trusting that there would never be
serious tightening.
True monetary tightening would have to show first of all in declining
"excess reserves" of banks relative to their reserve requirements. These
have remained at an elevated level during the rate-hike years of 2004-05.
In 1991, when the Fed tightened, credit expansion slowed sharply from
$866.9 billion in the prior year to $620.1 billion. A sharp slowdown in
credit expansion in 2000 to $1,605 billion also happened, from $2,044.7
billion the year before. Yet this still represented very strong credit
growth in comparison with the years until 1997.
Like all central banks, the Federal Reserve has two levers at its disposal
to stimulate or to retard credit and money creation. The big lever is its
open market operations, buying or selling government bonds, thereby
increasing the banking system's liquid reserves. The little lever consists
of altering its short-term interest rate, the federal funds rate, thereby
influencing the costs of credit.
It is most important to distinguish between the two instruments. True
monetary tightening has to show inexorably in a slower credit expansion
throughout the financial system. There is one sure way for a central bank
to enforce this, and that is by curtailing bank reserves through selling
government bonds.
The other lever at its disposal, as pointed out, is to influence credit
costs. But the influence of the central bank on credit costs begins and
ends with altering its short-term federal funds rate. During the past two
years, the Fed has raised its federal funds rate from 1% to 5.25%. But
long-term rates hardly budged. To the extent that borrowers shifted from
the low short-term rate to the long-term rate, they encountered higher
borrowing costs. But at the long end, interest rates rose less than the
inflation rate.
Here are still a few other credit figures illustrating the Fed's monetary
tightening since mid-2004. Total bank credit expanded, annualized, by
$957.0 billion in the first quarter of 2006, against $563.5 billion in
2004. For security brokers and dealers, the two numbers were $611.3
billion, against $231.9 billion; and for issuers of asset-backed
securities (ABSs), they were $663.3 billion and $322.6 billion. This is
monetary tightening à la Greenspan.
Monetary tightening has one purpose: to curb credit expansion fueling the
excess spending in the economy and the markets. By this measure,
Greenspan's monetary tightening since 2004 has been a sheer farce. During
these two years, he presided over a sharply accelerating credit boom, for
which the reason is also obvious.
To equate rising short-term rates automatically with monetary tightening
can, therefore, be a gross mistake. Later on, we shall explain that this
is the great error of the monetarists in assessing the development in 1929
and following years. Borrowing exploded during 1927-29, despite the Fed's
rate hikes, and then literally collapsed after the stock market crash.
It can be argued that rate hikes in the past have generally worked. Yes,
but the central bankers of the past never forgot to tighten bank reserves.
Tighter money to them meant tighter credit, and it always showed in
sharply shrinking credit figures. So it also has, in the past, in the
United States. But this time, the diametric opposite has happened.
There was reserve easing. Money and credit, moreover, only became
significantly more expensive at the short end. All the time, there was
nothing in this to slow the housing bubble and the associated borrowing
binge. Rising house prices easily offset the effect of rising short-term
rates.
Does this mean that the economy can continue to grow as before? No, not at
all. All excesses, if not stopped, are sure to exhaust themselves over
time. That is no less true for economies than for the human body. In our
view, the housing bubble is finished not because credit has become tight,
but because the borrowing excesses are running against natural barriers.
One such natural barrier is the affordability of housing and the limited
number of greater fools who are able and willing to pay these inflated
prices. At some point, excess supply will exceed demand. We read from
reliable sources that in June, sale offers of existing single-family homes
were up 35%, while actual sales were down 6.5% versus a year ago. So the
year-over-year "excess" supply was 42.2%.
Affordability is way down, units offered for sale are way up and price
appreciation has all but stopped. It is a radical change in the market
situation, which, however, has so far impacted economic activity only
moderately.
Past experience with housing bubbles suggests that the first effects are
in the steep fall of actual sales and in the lengthening of time until
sales materialize. The markets become illiquid. Until sellers capitulate
and accept lower prices, it can take a long time. In this way, apparent
price stability becomes increasingly treacherous over time.
Present American folklore has it that a protracted slump in house prices
is impossible. Let us say for many people it is unthinkable. And that is
precisely one reason why this housing bubble could go to such
unprecedented excess. The little historical knowledge we have about
bursting housing bubbles is from a study published by the International
Monetary Fund in its World Economic Outlook of April 2003. It presents
past experience in a very different light. Here are some excerpts on
decisive points:
"To qualify as a bust, a housing price contraction had to exceed 14%,
compared with 37% for equities. Housing price busts were slightly less
frequent than equity price crashes... Most housing price busts clustered
around 1980-82 and 1989-92, while equity price busts were more evenly
distributed across time.
Housing price crashes differ from equity price busts also in other three
important dimensions. First, the price corrections during house price
busts averaged 30%, reflecting the lower volatility of housing prices and
the lower liquidity in housing markets. Second, housing price crashes
lasted about four years, about 11/2 years longer than equity price busts.
Third, the association between booms and busts was stronger for housing
than for equity prices."
An important theme running through the foregoing analysis is that housing
price busts were associated with more severe macroeconomic developments
than equity price busts. Coupled with the fact that housing price booms
were more likely (than equity price booms) to be followed by busts, the
implication is that housing price booms present significant risks. For
this, the authors give the following reasons:
"Housing price busts have larger wealth effects on consumption than the
equity price busts...
"Housing price busts were associated with stronger and faster adverse
effects on the banking system than equity price busts... All major banking
crises in industrial countries during the postwar period coincided with
housing price busts.
"Price spillovers across asset classes matter, as evidenced by the fact
that housing price busts were more likely associated with generalized
asset price bear markets or even busts than equity price busts.
The authors then give a fourth reason, which was true in the past, but in
which the situation in America today radically differs:
"Housing price busts were associated with tighter monetary policy than
equity price busts, reflecting the fact that most housing price busts
occurred during either the late 1970s or the late 1980s, when reducing
inflation was an important policy objective. The disinflation increased
the real burden of debt, which exposed inflation-related overinvestment
and associated financial frailty."
Regards,
Kurt Richebächer
for The Daily Reckoning