Monday, 14 January 2008

Central banks - hoping for the best, fearing the worst

Inflation is back with a vengeance. Today, UK factory gate price growth reached 5 percent, giving a 16 year high. The retail price index is stuck above 4 percent while the Bank of England has missed its inflation target in 23 out of the last 24 months. The story is much the same in the US. Import prices are exploding while consumer price inflation is above 4 percent. Understandably, gold prices today cruised passed the $900 barrier.

Meanwhile, over in the US, Bernanke is promising more interest rate cuts, while over here the MPC look ready to knock 0.25 percent off the cost of borrowing next month. In principle, central banks are supposed to worry about price stability, but these days, central banks seem more interested in avoiding recessions. Why have they ignored the recent surge in inflation? Why do they fear an economic slowdown so much?

The answer in two words - household debt. Central banks - both in the UK and in the US - fear that an economic slowdown will increase default rates and weaken bank balance sheets. Central banks know that there is enough dubious debt out there - mortgages, unsecured loans, credit cards - to sink the financial system. If default rates increase enough it could lead to some banks drifting toward bankruptcy. Nothwithstanding all their brave words about price stability, central banks fear household debt more than inflation.

In their more optimistic moments, central bankers think that the current round of interest rate cuts will not actually be inflationary. Cuts will improve liquidity and allow banks to borrow to each other. It may also help banks to reduce their rates on teaser loans and therefore limit default rates. Central bankers hope that commercial banks have learnt some hard lessons in 2007 and that lower rates will not prompt a renewed burst of irresponsible lending. In this happy scenario, credit growth will be sufficient to avoid a recession but slow enough to prevent stoking up inflation.

Unfortunately, inflation doesn't respond to wishful thinking by central bankers. The cause of inflation is well understood, it is excessive monetary growth. However, monetary growth does not generate inflation in the same way that turning on a tap generates running water. Inflation works its mischief slowly, it takes its time when it decides to accelerate.

The inflation we have today is the consequences of poor central bank decisions taken two years ago. Lest we forget, two years ago, was early 2006, when the housing bubble had regained momentum and banks showered anyone who could fill in an application form with a cheap loan. At the time, the UK money supply was growing at double digit rates. As a consequence, the UK has a growing inflationary problem today.

Central banks must also come to terms with a second limitation of monetary policy. They can only control short term rates. Long term interest rates are determined by markets. Once inflation picks up, long term rates follow. This was why the 1970s were marked by stagflation, when the UK and the US had slow growth and rising inflation. Higher long term interest rates killed growth. It was only when central banks started to tackle inflation that long term rates fell and economies began to grow on a sustained basis.

The Fed and the Bank of England are cornered. Cutting rates might give some temporary relief to banks. However, higher inflation will push up long term interest rates and will bring on a recession. Both central banks know that a recession is inevitable, but both institutions hope that by the time an eocnomic slowdown arrives, commercial banks will have made sufficient preparations for a wave of personal sector defaults.

What does this mean for the UK housing market. Ultimately, house prices are driven by one thing - the availability of credit. Despite any future interest rate cuts that might appear in February, UK banks will not start lending again. Now is the time to repair balance sheets not feed the get-rich-quick-on-real-estate illusions of UK households.

The UK bubble is over and a quarter point rate cut in February will not make a difference. House prices are about to take a long awaited trip back to earth.


dirty digger said...

The more you say housing crash, the further it recedes into the distance. If the BoE continues to lower interest rates--regardless of inflationary pressures--prices will not tumble. Until they begin raising interest rates substantially (and they cannot do this, for obvious reasons), the market will stagnate, nothing more. Or less.

Anonymous said...

Hmm so if lenders tighten up their criteria and start refusing the silly loan multiples for mortgages or god forbid require substantial deposits before they would even concider giving mortgages to FTBs OR wont allow you to buy " up the ladder" as your seen as a risk due to the amount of debt you have already ( with your asset, ie your home depreciating in "value")..what will happen to house prices then?

dirty digger said...


Like me, you have no idea what will happen in the future. All the predictions of disaster will not be known as true until AFTER the event. So your forceful insistence (and UKHB's) that there will be a crash landing is no more valid than my own until some period in the future when we can look back and say "Aha!" All the wishing in the world does not make things come true. Or haven't you learned that yet? Until interest rates go UP, there will be no crash.

Anonymous said...

"All the wishing in the world does not make things come true. Or haven't you learned that yet? Until interest rates go UP, there will be no crash."

I have no wish either way, well thats not entirely true a correction in house prices benefits everyone apart from the banks :) ..but you are right, we dont really know for sure!

But - please bear with me here , what does interest rates have to do with it? If the banks simply wont lend money to those with bad risks ( which unfortunately they used to and lead to the financial mess in the first place), people cant MEW or move up the ladder arent interest rates irrelevant?

I digress...

so just for the fun of a thought experiment.. given my original scenario ( and I see evidence that this is actually happening by the way) will you answer the question of what you think will happen to house prices?

dirty digger said...

I think the housing market will stagnate, as I said. And some time in the next ten years the cost of living will catch up with house prices. Unless interest rates go up dramatically--to 10% or more. Then there will be a crash. Highly unlikely.

Towjam said...

Stagnation was what all were predicting here (US) when the market started to slow.
Hope the banks there weren’t as reckless as lenders here.
Did many people use ARM’s there?

Anonymous said...

Anyone who cannot see that house prices are overvalued must be stupid.

Like Alice said, inflation is built into the system now and is a vicious circle caused by high house prices - due to ease of credit.

Inflation will only get worse unless rates go up - which they will have to do eventually.