Midweek Mash-Up

The winter blues have hit, not just in the form of a big snow storm, but also in the form of a steady drizzle of mediocre news. There is nothing much to report, so let me collect a few small items into one.

1. House Prices: There are reports from around the country, most notably on internet real estate listing sites, that home prices are headed down again. This is after a few months of firming. This cannot be a surprise, yet it is being greeted by the financial media as an ominous sign of imminent worsening throughout the general economy. That’s not true. The cause and effect runs the other way round. It is because the general economy remains sluggish that the firming trend in home prices is giving way. I have been talking about this for months. Here’s the story: last summer and fall the housing market revived slightly because of the stimulus package – there was a ‘first time buyer’ tax credit. That brought a steady trickle of buyers onto the market at a time when they probably would not have been there without the stimulus. Demand was artificially bumped up from whatever its ‘natural’ rate was. That little boost to demand was sufficient to arrest the slide in home prices and even reverse it in some places. But the underlying, non-stimulus, price movement remained downwards. I suspect there was also a short burst of ‘pent-up’ demand – people who had money and had postponed moving while they waited to see if prices dropped some more. When these people saw prices firm they jumped into the market and bought. All that ‘pent-up’ demand does is to move the transaction from one time period to another – it does not add to total demand. With both these effects exhausted, and with aggregate demand in the economy still weak due to laggardly employment and wage experiences, there is only one way for prices to go: down again. And that’s what I expect to happen as we move into spring. Whether the normal spring surge in home buying materializes is the key factor we all now watch for. If it does prices will stop falling. If it doesn’t prices will drop throughout the year.
2. Trade: The trade deficit widened in December. That will take a bite out of fourth quarter GDP growth, when it revised later this month, and is the most likely trend this year for trade. Our basic problem: oil imports, re-emerged as the driver of rising imports. Both the price and consumption of oil rose sufficiently to overcome a 3.3%increase in exports. Overall, imports rose by 4.8% to $189.2 billion, with crude oil imports rising 9.2% by volume and about 1.0% in price. Exports reached $142.7 billion. Our problem now is the turmoil in Europe and its knock-on effects on world trade and currency movements. Throughout 2009 trade had been a very positive factor for GDP, and now it looks very much as if that trend will flatten out if not reverse. This means that our reliance on imports could dampen growth significantly this year making GDP growth of over 2% difficult to maintain.
3. Interest Rates: I must admit the nonsense spoken about interest rate can get tedious. All weekend long and throughout this week so far there has been talk of the Fed’s imminent release of its ‘exit strategy’. This is the magical plan that will, according to the pundits, set out the way in which the Fed undoes all the support that it gave the economy in 2008/2009. Don’t forget that to most of these pundits we are in dire danger of a massive burst of inflation due to the huge injection of cash that resulted from the Fed’s support. That overhang of cash is thought to be waiting in the wings to flood the economy and drive up prices unless the Fed can drain it beforehand. Setting aside the theoretical issues I have with this notion, the threat of inflation is so remote currently that I find it odd we even have to have this conversation. But such is the prevalence within the financial markets of the incorrect thinking underlying fears of inflation that the Fed seems compelled to announce such a plan. Guess what? Bernanke says that his concern is too little growth not much and that we will maintain low rates for the foreseeable future. Well duh! People who fear inflation have to be the same ones who imagine a rapid recovery. Since such a recovery is unlikely – I would argue it’s impossible – inflation simply will not be a problem this year or next. In fact there are still traces of deflationary pressures lingering – notably the enormous unused capacity overhang yet to be re-absorbed by growth. Until that overhang is gone businesses in most industries will have very little opportunity to pass along price increases to consumers. Therefore any price increases at the wholesale level will have to be absorbed by reducing profits. Besides I see no evidence of a boom in final, and especially consumer, demand. As Bernanke says: the threat is of too little activity, not too much. So short term rates are likely to stay flat. As for the longer term rates: the punditry is talking up the prospect of a bond market revolt over our budget deficit. If such a ‘revolt’ takes place we should see a sharp drop in demand for US bonds and hence the need to raise rates to offset that drop. So far there is no sign of such a movement. In fact US bonds are selling well. Why? Because everyone else is in the same hole. Which means that US bonds retain their relative – rather than absolute – attraction. So look for long term rates to stay where they are for a while, but also be aware that the trend will be upwards as the economy improves.
4. GDP Growth: Lastly, I should update my forecast for the year. The last quarter of 2009 saw a sudden burst of GDP growth, most of which was due to one time effects like the inventory switch I spoke about at the end of the year. Those one time movements have all washed through the numbers and some of the more lasting trends such as the trade improvement I mentioned above are due for a downward revision. It will be no surprise if the fourth quarter figure is reduced somewhat as better data is collected. Such revisions are normal and are particularly likely at times of changes in direction. Looking forward we must all disregard last year’s odd fluctuations and ask what growth is sustainable. The answer seems to be ‘not much’. As long as consumers continue retrenching their balance sheets by reducing debts, and the drop in consumer debt loads is now the biggest in history, I see very little impetus for strong growth. Ours is a consumption economy. Indeed our entire culture is built around consumption. We are not about to change that sufficiently to alter the shape of the economy in aggregate – it will take years to instill a thrift based mentality here. So if consumption fails to ignite so does the economy. While there are signs of the severe drop in demand of 2008/2009 ending there are no signs of acceleration either. With credit markets weak as the banks rebuild capital and avoid making bad loans, with state governments cutting spending in order to balance local budgets, and with trade flattening out or even weakening, projecting GDP growth of over 2% becomes very difficult. Odd movements in inventories could occur, but the underlying economy looks set for a very slow year. So I am sticking with my forecast of 1.5% to 2.0% growth for now.