A booming housing market, high levels of consumer borrowing, a pick-up in
consumer price inflation, a balance of payments that is heavily in the red and a
large fiscal deficit all point to an economy that is heading for a bit of a
bump. Familiar as it may sound, this catalogue of woes refers to the US rather
than the UK. And, while the prospect of a recession in the world’s largest
economy is at the extreme end of the forecasting range at the moment, the ‘r’
word has re-entered analysts’ vocabulary. At the very least, a short-term
slowdown is very much on the cards.
Over the past two or three years, the world economy has been growing very
robustly at rates of between 4% and 5% and, as ever, the US has been at the
heart of the growth. After the brief recession in 2001, which followed the
ending of the dotcom bubble, US growth picked up and since 2004 has been above
3% per year.
The primary driver behind the slide into mild recession five years ago was
the squeeze on company profits and the pressing need for business to run down
borrowings, which led to sharp decreases in investment spending. As companies
reduced their debt, households were persuaded to take on more. The Federal
Reserve took steps to bring this about, by cutting interest rates from 6% to
just 1% – where they were held for more than a year. The Bush administration
played its part with an unprecedented programme of tax cuts, which amounted to
around 6% of GDP between 2001 and 2004.
Predictably, American households responded by stoking up spending and
borrowing. As in the UK, the housing market was at the centre of the action. As
the number of transactions rose, so did prices and increased borrowing was the
obvious consequence. Outstanding mortgage debt of $5.1 trillion at the end of
2001 had virtually doubled by June 2006. In addition, an estimated $1.3 trillion
of additional borrowing came through in the form of mortgage equity withdrawal.
While boosting the pace of economic activity, the policy also held the seeds
of its own destruction, and the day of reckoning is now looming. Steadily rising
inflation was the most obvious sign of an overheated consumer sector and a
balance of payments deficit that is now around 7% of GDP is a clear sign of an
unbalanced economy. The long-term result of the US acting as the world’s
‘consumer of last resort’ has been a surge in the dollar assets held by Asian
Given its remit, the Federal Reserve could not be complacent about the rise
in inflation, which topped 4% at one point. Inflation was already edging up when
oil prices moved rapidly north. Since fuel taxes are proportionately lower in
the US, higher oil prices had a much bigger impact on living costs than in
Europe. So, at each of its 17 six-weekly meetings between June 2004 and June
2006, the Fed added 0.25 percentage points to its benchmark rate, taking it from
1% to 5.25%.
This was clearly going to hurt and the pain is now being felt. Growth slowed
to a more modest 0.7% in the second quarter (following an unsustainable 1.4% in
the first three months of 2006) and the pace of job creation has slackened. The
non-farm payrolls measure of employment (closely watched and published on the
first Friday of every month) slipped from an average of 175,000 per month in the
first quarter to just 51,000 in September.
But it is the housing market that has most felt the pinch, with confidence
draining away as affordability gets stretched. In a ‘bubble zone’ of 18 states
and Washington DC (which accounts for about half of US GDP), housing is now less
affordable than London. From the second quarter, prices have stopped rising, the
volumes of transactions has slowed and the number of new homes being built and
building permits granted have fallen. To call it a tailspin is probably an
exaggeration, but it is certainly a sharp correction.
This downturn in the housing market has coincided with other strains and
stresses on households’ disposable incomes. After adjusting for higher debt
repayments, higher taxes and general consumer price inflation, an apparently
healthy 7% growth in nominal incomes translates into a mere 1% increase in
discretionary spending power.
Faced with the prospect of an imminent slowdown (GDP is likely to rise by
around 2% next year, the slowest for five years), the Federal Reserve stopped
hiking rates at its last two meetings and there is a growing view that the next
move in rates will be down. This, in turn, will further undermine the dollar,
thus making life harder for British exporters to the US. On the plus side,
weaker growth in the US will take the froth off commodity markets, including oil
and, therefore, ease the inflationary pressures for British companies.
It may no longer be true to say that when the US sneezes, the UK catches a
cold, but we will certainly feel the impact of a US slowdown. This will come via
a weaker dollar, tighter export markets and weaker returns to British companies
on their US investments.
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