Location: New York
Author: Shahin Shojai
Date: Tuesday, January 22, 2008
The U.K. economy seems to be facing many of the same challenges that the U.S. has been facing for the past 8 to 10 months. A sharp fall in U.S. house property prices, and the belt tightening by the banks, has meant that homes cannot be so easily used as cash machines to finance life styles by many citizens.
As the consumer spending and confidence has been hit the risk of recession seems to have increased. Of course, there are many economists who feel that a fall in house prices should have little or no effect on the economy since ceteris paribus the losses faced by the house owners will be offset by the gains made by those who wish to buy the now cheaper homes, many of whom are first time buyers wishing to get onto the property ladder.
But, of course, life rarely has a situation where ceteris paribus holds. In an environment where house prices have been used by many citizens to finance their life styles, a fall in that price would mean that they will spend less. For an economy that is highly reliant on consumer spending that could, without ceteris paribus, have significant implications and could cause those same people waiting to get on the property ladder to lose their jobs and not be able to afford the homes at all anymore.
That is certainly what is happening in the U.S. The number of unemployed does seem to be going up, meaning that a fewer number of those people will be able to afford to buy new homes or even keep the ones they are living in. The combination of a falling dollar and house prices, and rising oil prices and unemployment has meant that the Federal Reserve is stuck between a rock and a hard place.
If it raises interest rates to control inflation, the property crisis gets worse and recession will be more likely. If it lowers rates, inflation, which is already getting out of hand, can rise quite sharply. Of course, those who demand a loosening of monetary policy can find some data to support their propositions to cut rates. They exclude the highly volatile food and energy prices, as if people don’t actually pay for them.
Interestingly those same economists who suggest that a fall in house prices will have no impact on the economy are asking the Fed to cut rates sharply in order to avoid a recession that could be caused by a fall in consumer spending brought about by a fall in property prices.
The U.K. economy, which like the U.S. is also highly asset-dependent, seems to be experiencing similar problems, though unemployment has remained low. House prices are going down, credit is not so easily available, and inflation has been above the central bank’s target for a while now. If the speed of the property market correction increases, as is quite likely, the risks facing the U.K. economy will be as severe as those that the U.S. is currently facing and greater unemployment will certainly follow.
In fact, it could be even worse. One of the factors that has allowed the U.K. inflation to remain somewhat more benign is the strength of the sterling, which has appreciate against the dollar by around 16% over the past 2 years. This rise had also helped mitigate the impact of rising oil prices.
However, in recent weeks there are rumours that sterling would fall back to the levels of 2006, basically wiping out these gains, at the same time that energy prices seem to be stabilizing at prices that are many times what they were a few years ago.
The U.K., similar to the U.S., also has a large current account deficit, in fact bigger as a percentage of GDP. Consequently, if there is a fall in the value of sterling, and there are many who believe that there will be, the risk of importing inflation increases. However, unlike the U.S., the U.K. is not a major exporter of physical goods and the benefits of a fall in sterling would, therefore, not be as great.
Another important difference with the U.S. is that a fall in sterling is not everyone else’s problem; it is primarily an issue for the U.K. and its authorities. Dollar is able to benefit from its position as the major global reserve currency and a currency to which many of the other major currencies in the world are pegged. Sterling is not.
So, what should the Bank of England do in such a situation? Should it follow the lead of the Federal Reserve and reduce rates to avoid a recession? If it does the sterling will certainly fall much more severely than many anticipate. Many foreign investors who benefited from high interest rates combined with an appreciating currency will reconsider their exposure to sterling.
The risk of inflation would be exacerbated. In addition, as the U.S. experience demonstrates, imports will not fall dramatically with a fall in the currency and the current account balance will not improve much, especially since U.K. is not as big an exporter as the U.S. If the Bank of England keeps interest rates constant, or even raises them, to control inflation the pressure on home owners will remain and consumer spending might fall, as it seems to have already started to do so; increasing the likelihood of a more severe slowdown.
Based on the aforementioned issues, we can see that the Bank of England is facing a much more difficult task than the Fed and it requires the kinds of expertise that simply do not exist anywhere in the world. There are no precedents for the kind of environment we are in currently, where personal credit plays such an important role in economic growth. A severe slowdown in that relationship could have implications that few, if anyone, really understands. Let us hope that the Bank can sail through these winds as wisely as possible; which means not listening to professional economists and journalists.
This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).
To subscribe or visit go to: http://www.riskcenter.com