A tightening farce

Dr Kurt Richebacher - Thu 14 Sep, 2006

"...The fact is that the US credit expansion has sharply accelerated during these two years of rate hikes instead of decelerating. Borrowers and lenders simply adjusted to the higher rates and lenders kept lending..."

 
There is total detachment from the bad news now pouring
out of the US economy. For several years, the booming
housing market has made the difference between recession
and recovery for the US 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 US economy’s recovery from the recession in 2001 has
been its slowest in the whole post-war 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 US Bureau of Labor Statistics (BLS) reported on
Aug. 16 that the CPI Inflation 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 US 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 fuelling 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.
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.”