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The Monthly Banker: 13 December 2006
Weak dollar dampens desire to tighten in Europe
The financial markets believe that the US economy is heading for recession and have eased monetary conditions accordingly. The Fed meanwhile pleads a lack of visibility on inflation and has become increasingly comfortable with rates at 5.25%, where they have been since June.
The usurped Fed thus appears like an innocent bystander watching traders speed along the market’s highways blissfully unaware of the fog that has been obscuring the views of Mr Bernanke and his colleagues.
It may yet all end in a smash, but the Fed is no innocent bystander. For a start such fog as there might be is largely of the Fed’s own making, resulting from its excessive use of monetary accommodation between 2002 and right into 2005. Fearing a decade of Japanese-style deflation the Fed railed against a recession that never actually materialised with 1% interest rates. The era of easy money inflated the property bubble, which in bursting now threatens to take the economy down with it.
The only real surprise about all this is that it has taken so long for the dollar to start to react. Dollar weakness was the maven call for 2005 after euro-dollar hit all time highs in the last week of December 2004. Despite this euro-dollar actually fell almost 13% between then and the following December.
This year has gone a little more to plan. When the dollar headed southwards in April/May, there was no meaningful rebound, paving the way for the latest bout of dollar weakness.
Though long overdue, the dollar’s sudden lurch southwards has come at a rather inconvenient time for Chairman Bernanke, Governor King and President Trichet.
As we mentioned above, the Fed has been getting quite comfortable with its current monetary stance. Instead of hiking rates and playing down the risk of inflation, it is doing precisely the opposite and rates have been steady at 5.25% since June as a result.
The Fed’s central view is that inflation has indeed peaked, but that the risk remains to the upside. It also believes that while the housing market might well slow the broader economy, it won’t actually trigger a recession by throwing growth into reverse.
The market’s viewpoint is somewhat different. It couldn’t give a stuff about inflation just at the moment and only reacts to strong economic data because it delays the easing that traders suppose will eventually follow. Instead it is becoming increasingly concerned that the bursting of the real estate bubble threatens the general health of the economy.
The upshot is that the inflation rate discounted by US index-linked bonds has been falling steadily since the first quarter. At the same time the conventional yield curve is inverted to such a degree that the quants who model these things suggest that there is a 50/50 chance of a recession in a year’s time.
This in turn has led to the somewhat counter-intuitive suggestion by some that the Fed needs to cut interest rates, possibly as soon as this week, to prevent further dollar weakness. I’ve struggled with that one a little, but I guess the driving analogy would be steering into a skid in order to regain control of your vehicle before taking evasive action.
While a cut at this point in time would probably be taking things a tad too far, the three major western central banks have certainly all moderated their hawkishness to some extent.
Fed officials are still jawing about inflation, indeed more so than when Mr Bernanke first tried out Alan Greenspan’s chair. However, they are now at least conceding that the housing market’s slowdown could possibly have a greater impact than they had at first thought.
In the UK there were signs that the Bank of England was going “soft” even as the committee voted to hike rates last month. The minutes of that meeting showed that no less a figure than the deputy governor Rachel Lomax herself had dissented from the majority view and voted against the hike.
While it has been suggested before that Ms Lomax was inclined to be rather dismissive of the impact that house price inflation might have on consumer demand (not least in November’s Monthly Banker), few had imagined she’d go so far.
With the pound now fast approaching the critical $2 level, it isn’t hard to imagine that other committee members might also have lost their appetite for further monetary tightening.
In Europe the ECB’s President Trichet has also toned down his language, although that didn’t prevent his colleagues from voting for a further increase in interest rates last week. Mr Trichet’s communication of his Bank’s monetary intentions is highly nuanced at the best of times, leaving analysts in severe danger of misinterpreting the nods and winks that pass for communication in Frankfurt. Notwithstanding the linguistic intrigues, it does appear that the ECB is at least considering a slightly longer gap between rate hikes so that it can assess the changing conditions. It has also rather conveniently produced forecasts suggesting that inflation might not be such a grave threat going forward.
The problem for central bankers and the market alike is that even if their predictions are spot on (and that’s a big if), they will not know whether they have called the economy correctly for up to six months. Put another way, even if the housing market’s implosion does trigger a recession, we’ll probably have to wait until late Q1 or early Q2 next year before even construction jobs start to evaporate given the sheer number of houses still in mid build.
In the meantime last week’s upwards revision to the employment data suggest that rather than creating an average of just over 100,000 jobs a month, the US economy is adding something in excess of 150,000 jobs. This level of job creation might well be enough to head off the more dire effects of the fall in house prices.
This point is critical. Historically the only really serious economic metric for the housing market is unemployment. Even a sharp fall in house prices is not such a big deal if owners aren’t forced by unemployment to crystallize their losses: although clearly consumer demand will take some sort of hit from the reduction in real estate equity (no matter what Rachel Lomax might believe).
Given all the above, our “central view” is actually quite closely aligned to the central banks’. The US economy will slow in the first half of 2007, but won’t enter recession. At the same time we might also find that good old fashioned inflation makes a very modest come back later in the year. Not enough to cause any great worry outside central banking circles, but probably sufficient for global interest rates to end 2007 higher than they look like finishing 2006.
Investors Intelligence economic correspondent