UK as harbinger for US economy
All signs are that the Bank of England is beginning to rue its August 2004 interest rate hike. That final round of tightening took the repo rate to 4.75%. Since that time, UK home price inflation has fallen from 18.9% to 4.1%; home sales fell from a seasonally-adjusted 96,000 per month to 53,000; mortgage equity withdrawl fell from £11.3bn a quarter to under £7bn (2005:I data to be released on July 8); retail sales volume peaked the following month and has not recovered, with June turning in the worst monthly showing in 22 years; and GDP growth has fallen precipitously from a 3.1% annual growth rate to 2.1% today.
The heavy dependence of the UK economy on housing and its salutary effects on retail sales is only heightened in the US. Thus I have to agree with Paul Kasriel today when he argues that the Fed is going to be stopping rate hikes sooner rather than later -- regardless of what the Greenspanspeak is.
The Fed does not want to risk a rapid deflation of the housing bubble at this juncture. If the housing bubble were to burst in the next year, it would have the potential of precipitating a serious recession. As my colleague, Asha Bangalore, reported, housing-related employment has accounted for 43% of the increase in private nonfarm payrolls since this recovery/expansion got started. So, a sharp fall off in housing activity could have a significant negative impact on employment growth. Because households have been extracting large amounts of equity from their homes -- $324 billion in 2004 - to maintain their high levels of consumer spending relative to their after-tax incomes, a bursting of the housing bubble would also have an indirect negative impact on consumer spending inasmuch as "tappable" home equity would rise more slowly. Last, but by no means least, the bursting of the housing bubble could cripple the banking system in that over 60% of commercial bank loans and investments are mortgage related - mortgages, mortgage backed securities, home equity loans and the liabilities of government sponsored enterprises such as Fannie Mae and Freddie Mac.Note as well that while disposable household(UK)/personal(US) income has growth at a very similar rate in both countries over the past five years -- 24.2% in the UK, 26.7% in the US (nominal) -- British residents have managed to save 4-7% of that income every quarter. Americans have saved 1-3.5% of their income every quarter.
And don't forget that as the Fed raises rates, everybody else is cutting or contemplating cutting. Higher US rates merely encourage more of the capital glut to flow into US securities, pushing up the dollar further and exacerbating the current account deficit. With so many export-dependent economies in the world today, they'll only be too happy to plow even more investment capital (secured through ultra-cheap loans) into their tradable sectors and sell to Americans with their stronger currency.
The American economy is riding an asset wave, and the Fed will do what it can to keep it from crashing down on the reckless surfers riding it. One hopes the Fed is also thinking a CA deficit of 7% of GDP is too big for comfort. I'm bold enough to make a prediction: the Fed takes a breather at 3.50%.