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Excellent Commentary From Moneyweek

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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.

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 Stanley‘s Andy Xie says, the old idea of taking away the punch bowl before the economy starts partying too hard has become anathema to today‘s 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 that‘s 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.

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