How the 'Bernanke put' means recession is inevitable

published 19 September 2007

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It's been a bad week for the US property market.

Sales of existing homes fell to the lowest in two years in July, while yesterday data revealed that new-home sales fell 4.3% in the same month, down 22% on last year. Median house prices are practically unchanged on a year ago, at $230,000 compared to $229,000.

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This does not bode well for the debt-laden US consumer. But US stock markets seem fairly untroubled. Housebuilders' stocks may have dived sharply, but the S&P 500 index remains near its high-point for the year.

Could this be because investors are confident that the housing market slowdown is just the excuse the Federal Reserve has been looking for to cut interest rates?

Simon Hayley at Capital Economics points out that Wall Street is already putting its faith in the Bernanke put'. This is the belief that new Fed chief Ben Bernanke will cut rates to bail out stock markets - and now homeowners, too - just as his predecessor Alan Greenspan did any time it looked like something bad was going to happen to the US economy.

"Investors appear again to have concluded that as long as the Fed is able to cut interest rates everything will be all right," he says. It's not surprising they feel like this. Earlier this month, Mr Bernanke and his comrades called a halt to a 17-strong series of rate hikes, despite the fact that the Fed's favoured measure of inflation is running at 2.4%, well above its comfort zone' of 1% to 2%.

As Morgan Stanleys Andy Xie says, the old idea of taking away the punch bowl before the economy starts partying too hard has become anathema to todays central bankers. "Central bankers today look suspiciously like Santa Claus. They provide more booze and nibbles when the party starts to run low. They nurse bubbles like doting grandparents."

He continues: "When inflation happens, central bank pampering is supposed to stop - like doting grandparents running out of money. However, a new trick is being discovered to fill the hole. The data-dependent Fed suddenly wants us to ignore current inflation and focus on a future with no inflation."

Mr Xie puts his finger on the problem in a single sentence. "The basic reason for rising inflation is that global real policy rates are less than half of, and global inflation 50% above, average levels over the past decade." In other words, interest rates aren't high enough to make a dent in inflation.

He argues that the Fed is trying to pull the wool over people's eyes by suggesting that the weak housing market will slow down the US economy, which in turn will bring down inflation. Central banks are also still trying to peddle the argument that oil prices will come down, or at least stay flat, so that even though they're still at record levels, they won't be much higher than a year ago, which technically means less inflation.

But all of this is a distraction from the real drivers of inflation. "The bottom line is that money supply is too high and real interest rates [that is, interest rates adjusted for inflation] too low for price stability."

Mr Xie's argument is very simple - the same one in fact, that we've been making for some time now. Central banks are reluctant to tackle inflation by raising interest rates. That's because artificially low rates have now boosted both house prices and stock markets to bubble proportions - in fact, "the ratio of property and stock market value to GDP in the global economy has risen by about 50% in the past decade."

If you're a believer in mean reversion - in other words, that things return to their long-term averages eventually - that means that either global economic growth has to soar, or property and stock market values have to plunge. And as global economic growth is currently unusually strong, the former seems unlikely. So if banks keep putting interest rates up, there's likely to be a painful correction in both house prices and shares.

But the longer the banks put it off, the more likely a price-wage spiral is to take off. This is what happens when people finally realise that their cost of living is soaring, and demand rising wages to match. In turn, wage hikes increase companies' costs, which means they raise the prices of their goods further to compensate, and so it continues in an increasingly vicious circle.

As you may have noticed in recent weeks, even the mainstream press is starting to catch on to the fact that inflation is actually a lot higher than the Government likes to let on. Articles from The Independent to The Telegraph have been pointing to the significant flaws in the official consumer price inflation measure - which suggests that the penny may now be dropping with consumers at large.

The trouble is, there's only one way to stop a price-wage spiral - and thats to hike interest rates aggressively, causing a recession and driving up unemployment. People don't ask for more wages when their colleagues are being laid-off left, right and centre. Of course, that would also mean a lot more pain for homeowners and equity investors.

"The more dovish the central banks are today, the higher the risk of this hard landing scenario," says Mr Xie. But things may already have gone too far. With the unprecedented levels of debt accumulated on both sides of the Atlantic, it strikes us that any significant tightening will be extremely painful. But pain now is still a lot better than a currency meltdown at some point in the near future.

One thing's for sure - we certainly wouldn't want to be in Mervyn King or Mr Bernanke's shoes right now.

Turning to the stock markets

Weak US housing data saw the FTSE 100 fall from a session high of 5,892 to end the day just 9 points higher at 5,869. Solid results from packaging and beverage maker Rexam saw it make the greatest gains of the day, its share price rising 7% on 'buy' advice from brokers. Rentokil was the day's biggest loser, having cut back guidance for full year profits on some divisions due to difficult market and trading conditions. For a full market report, see: London market close

On the continent, a strong utilities sector saw the German Dax-30 gain 38 points to end the day at 5,814. The Paris Cac-40 also closed higher, up 30 points to 5,112. The gains were led by aerospace company EADS.

Across the Atlantic, a mixed reaction to the latest economic data saw stocks close the day with modest gains, although the retail sector suffered losses. The Dow Jones was 6 points higher at 11,304. The Nasdaq was two points higher at 2,137. And the S&P 500 ended the day 3 points higher at 1,296.

In Asia, the Nikkei 225 gave up the morning's gains to end the day 21 points lower, at 15,938.

The price of crude oil climbed back above $73 a barrel, trading at $73.04 in New York this morning. While in London, Brent spot was at $72.40.

Spot gold was trading at $620.30 an ounce in New York late last night. Silver seemed to be losing some strength yesterday, last trading at $12.36.

Last night, computer company Apple announced the recall of £1.8m laptop batteries, after reports of overheating and minor injuries to two US customers. The recall is the second in ten days involving batteries made by Sony, after lithium-ion batteries in Dell laptops had reportedly caused some to burst into flames. In Japan this morning, Sony shares fell by as much as 3%, although Nasdaq-listed Apple shares have so far suffered no negative effects.

And our two recommended articles for today...

Why these are dangerous times for metals speculators

- The metals buying frenzy which began around the middle of last year has come to an end, says Paul van Eeden. But in that time, the prices of all metals - even gold - were pushed too high. And now metals face the double threat of a correction combined with an economic slowdown. What should investors do? Find out how you can win, whatever happens, by reading: Why these are dangerous times for metals speculators

Is it safe to rely on your home as a pension?

- For the asset-rich, cash poor generation, using your home to support your retirement may seem like a good idea. But the rule is still 'buyer beware', says MoneyWeek's Jody Clarke. In this article - just available to non-subscribers - he looks at why you could end up paying a lot more than you expected. If you're thinking about an equity release scheme or lifetime mortgage, then you need to read: Is it safe to rely on your home as a pension?

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.