America braces itself for a second dipBy Krishna Guha
Published: July 17 2008 21:54 | Last updated: July 17 2008 21:54
For Janet Yellen, president of the Federal Reserve Bank of San Francisco, the forces that began threatening the US economy nearly a year ago are "a bit like the opening of
Macbeth, with the three ghastly witches brewing up trouble amid thunder and lightning". She adds: "Only here, the three troublemakers are the housing market, the financial markets and commodity prices."
<h3 class="section">EDITOR'S CHOICE</h3>
In depth: US downturn - Jul-16Sharpest rise in US prices for 17 years - Jul-16Editorial comment: Monetary minefield - Jul-16Comment: Finance and the Fed - Jul-16Bernanke highlights risks facing US economy - Jul-15Fresh data add to US economic woes - Jul-15Almost a year on, those three troublemakers are still very much at work. Financial markets remain in turmoil and the fate of the US economy once more hangs in the balance. Growth this quarter is shaping up to be quite strong. But the risk of a relapse into very weak growth or even recession has increased. The core dynamic of the credit squeeze financial weakness and economic weakness feeding off each other has intensified recently, reinforced by the shock from oil.
Yet the danger of high inflation becoming embedded in the US economy has also escalated, with rapid energy price increases pushing headline consumer price rises to 5 per cent year-on-year and driving up at least some measures of future inflation expectations.
The latest big intervention by the US authorities the rescue plan for
Fannie Mae and
Freddie Mac has secured the troubled mortgage giants' access to funds and with it a continued flow of finance for the beleaguered housing sector. But it provoked little immediate reaction in the wider financial markets. Indeed, financial shares fell further in the days following the Fannie and Freddie rescue, before rebounding strongly in midweek, in a sharp reminder that neither stocks nor the US economy offer a one-way bet.
Economists and investors alike are left wondering where we are in the credit crisis: whether, to borrow from baseball, the US is in the eighth inning or the fourth inning of a nine-inning game. For a while it looked as though the Bear rescue marked the turning point of the credit crisis. Now it is clear that while it marked a turning point in the crisis, it did not mark
the turning point. There is little reason to think that
the Fannie and Freddie intervention will mark the ultimate turning point either.
Fannie's and Freddie's debt was always seen as implicitly backed by the government. Their rescue closes off one avenue to financial and economic disaster. But it does not greatly improve the situation of other financial groups. As terrifying as the possibility of a Fannie or Freddie default might be, it was only one factor in the contest of forces weighing on financial markets and the economy.
On the one hand, after a shaky start to the year, the US economy has proved remarkably resilient through the spring and early summer. Gross domestic product might have contracted in some individual months, but across the first half as a whole it expanded at a stronger than expected pace. The US has continued to benefit from global growth, with exports providing an essential support for economic activity. But consumer spending has also held up much better than many including the Federal Reserve Board had expected.
At their last meeting in June, Fed officials revised up their "central tendency" forecasts for growth this year to reflect the first-half performance. They now expect growth this year (on a fourth-quarter-to-fourth-quarter basis) to come in at 1-1.6 per cent, compared with their April expectation for 2008 of just 0.3-1.2 per cent.
On the other hand, the economy is in increasing danger of deteriorating again later this year. The forces at work are the same three "witches" that threatened the US from the outset of the crisis. While there have been occasional glimpses of hope on all three fronts, overall, these negative forces intensified over the past two months. As a result, a growing number of economists are predicting
a "W-shaped" downturn, with some forecasting outright contraction around the turn of the year.
Depending on how economists ultimately classify the period of weakness at the start of this year, the year-end could mark the moment when the US finally falls into recession or tips back into it. "I think there is a better than 50-50 chance that we see a double-dip recession," says Richard Berner, chief US economist at Morgan Stanley. He says the consumer is being buffeted and the headwinds have only grown worse of late.
At the core of the threat to growth is the resumption of the basic dynamic of the credit crisis: a negative-feedback loop from a damaged financial sector to the real economy and back again. This is aggravated by the decline in house and stock prices that reduces the collateral available to support loans.
From its high in the middle of May, the S&P 500 financials index fell 37 per cent to its low on Tuesday before bouncing back in the past 48 hours to trade on Thursday at nearly 15 per cent below the low reached in March at the time of the Bear crisis.
Amazingly enough, banks still do not know the ultimate extent of their losses on complex new credit securities. Now, they are taking a second wave of losses caused by rising delinquencies on a wide range of loans that have been put under stress by economic weakness. There is nothing unusual about these losses they are part of an old-fashioned credit cycle. The problem is that the banks are entering this phase with their capital already impaired by the previous wave of markdowns. At the same time, financial groups are desperately trying to reduce their leverage, in response to increased volatility and to a market demand for solid counterparties.
"Who is driving deleveraging? In short, all of us," says Jan Loeys, strategist at JPMorgan Chase. "We as institutions: as banks, hedge funds and broker-dealers." But "it is very hard for the overall system to deleverage", he says.
Many analysts are concerned that there will be a rash of bank failures. But even if there were not, banks unable or unwilling to raise expensive equity could further cut back on lending, intensifying the credit squeeze in the economy. "In many cases banks are deleveraging or shrinking or are reluctant to raise the extra capital needed to take advantage of business opportunities," Ben Bernanke, the Fed chairman,
told Congress this week.
The difficulties in the financial sector are closely linked to uncertainty over the economic outlook and, above all, the outlook for housing. House prices have a powerful effect on consumer spending through their impact on wealth and on access to credit. They also affect financial institutions through their influence on mortgage defaults and the value of mortgage-backed securities. According to the S&P Case-Shiller 10-cities index, house prices are down 19 per cent from their peak and, based on futures trading, are expected to fall 30 per cent in all before bottoming out. This measure, which captures only the main metropolitan areas, is seen as exaggerating the likely nationwide price decline. But as Fed policymakers observed in the minutes of their June policy meeting, the outlook for housing remains "bleak".
While some affordability measures have improved, prices remain high relative to rents. Inventories of unsold homes are at elevated levels and the downward momentum in house prices shows no sign of abating.
There is a danger that house prices could undershoot fair value on the way down, just as they overshot it on the way up. More than 500,000 mortgages began the foreclosure process in the first quarter and in some localities there is evidence of "foreclosure spirals", in which falling prices push up foreclosures, in turn driving prices still lower.
"The asset price deflation in housing makes it very difficult to stabilise the financial system's balance sheets; it also accentuates the headwinds facing the real economy," says Mohamed El-Erian, co-chief executive at Pimco, the bond fund manager.
Overlaid on the credit squeeze is the additional shock from oil, which may prove to be the decisive factor that tips the economy into recession. Most analysis focuses on the effect of oil on inflation. But the jump in petrol prices also imposes a big tax on US consumers. Since the start of the year, moreover, rapid increases in food and energy prices have essentially eaten up nominal wage growth, leaving no growth in real labour incomes to support consumption.
With the pressure from the credit squeeze, housing, oil and a softening jobs market, the wonder is that the US economy has been as resilient as it has to date. First-quarter growth was revised upward to 1 per cent. For the second quarter, growth could come in at 2 to 2.5 per cent not far below the country's long-term trend.
A large chunk of the first half's strength will have come from net exports. But consumer spending has continued to grow, in part the result of $110bn (£55bn, 69bn) in tax rebates sent out from May onwards. These rebates appear to have had a strong immediate impact on spending, boosting consumption growth by perhaps 2 percentage points. But the stimulus is temporary and will fade in the second half of this year.
There may be another reason why spending is holding up for now, yet may fade as the second half unfolds. The time lag between the credit crisis in the financial sector and the peak of the credit squeeze in the real economy may simply be longer than initially anticipated.
At the onset of the credit crisis last August, banks had already committed large unused lines of credit to companies and to individuals (in the shape of home equity lines of credit, credit cards with generous lines of credit and the like). Since the start of this year, lenders have been cutting back on new credit lines and trying to pare back old ones. But cancelling existing lines is not easy and many borrowers have been able to draw on pre-authorised credit.
Moreover, coming into the crisis, companies were generating lots of cash. This self-generated cash provided a buffer against reduced credit. But it is gradually being eroded by a weak economy. Lawrence Summers, a Harvard professor and former Treasury secretary, says the peak impact of the credit squeeze on the real economy is probably still to come. "I would be surprised if it had peaked already," he says.
Yet at the same time, the US faces a very serious inflation risk. The 5 per cent inflation reached in June is unlikely to be the peak. In essence, it is externally generated, driven up by record prices for globally traded oil and food. But the longer it persists, the greater the risk that it could become embedded in domestic prices. Some measures of inflation expectations are flashing an alert. Core inflation (excluding food and energy) crept higher last month.
There is clearly some chance that the economy, after turning out to be stronger than most economists expected in the first half, could sustain this momentum in the second six months of the year. Persistent growth could, moreover, also indicate that the US is less vulnerable to financial market dislocations than generally thought. If that is the case, growth could quickly return to normal levels or higher, fuelled by very low real interest rates and an expected stabilisation in home construction, particularly if financial strains ease again.
That could swiftly reduce the currently modest amount of economic slack unemployment is still only 5.5 per cent and greatly aggravate the risk that high inflation becomes embedded in domestic wage and price setting behaviour.
Even if growth does not turn out to be stronger than expected, there is still some risk that inflation expectations could take off despite a weak economy. In effect, workers might accept little or no increase in expected real wages but demand full compensation for higher prices as they did in the 1970s.
If the Fed miscalculates, the US could have a serious inflation problem on its hands. But if it responds to inflation risk appropriately, the result will be to amplify the growth risk. At a minimum, unless the price of oil suddenly subsides or the economy enters a crater, the most the Fed will be able to do is to put off the day when it has to start raising rates again.
Moreover, if inflation expectations worsen further, the US central bank would have to abandon its balancing act and raise rates, in spite of the consequences for growth. This raises the question of what, if anything, the authorities could still do to reduce the growth risks without compounding the inflation risks.
While policymakers have been able to moderate the impact of the financial crisis and close off particular routes to economic Armageddon, they have not been able to break the underlying dynamic. With monetary policy at full stretch given the threat from inflation the bulk of any future policy response will have to come from the fiscal authority: the US government.
Hank Paulson, the Treasury secretary, has
taken the view that the government should if necessary intervene to ensure the stability of the system as a whole but let individual institutions, companies and households work through their problems. The Bush administration argues that markets will naturally stabilise if left alone, as prices fall to levels that attract new buyers.
It could be right. The bounce-back in financial stocks this week demonstrates that at a certain price investors are willing to take on risks. At some stage house prices will reach an equilibrium point at which buyers return to match supply; then if not before the credit crisis will be over. Moreover, the task of balancing growth and inflation risks could become less difficult if the oil price subsides. The decline in crude prices this week raises the tantalising possibility that oil could be easing its grip on the economy.
But Mr El-Erian of Pimco says there may be "multiple unstable equilibria" for house prices, the financial sector and the economy. In other words, there could be a "good equilibrium" higher house prices, recovering banks, a stronger economy and a "bad equilibrium" lower house prices, troubled banks and a weak economy. Or there could be other intermediate outcomes.
Mr Summers wants a second fiscal stimulus to prop up the economy while the housing market adjusts, reducing the risk that the jobs market could collapse, driving house prices still lower. Others think policymakers should focus on more targeted interventions to reduce the risk that house prices will undershoot fair value.
Martin Feldstein, a professor at Harvard, says: "The key is to take away the incentive for people to default on their mortgage when they have negative equity, because that will drive house prices down further."
Whether the interventionists are right or not, if the feared economic weakness materialises, the next president of the US could take office in very difficult circumstances. Ambitions for foreign policy, tax cuts and domestic reform might have to take second place to figuring out a way to revitalise the economy.
Copyright The Financial Times Limited 2008
ASIA HAND
Nightmare on Wall Street: Washington Can't Bail out the Sea of Red Ink
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