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The US housing bubble has popped - what now?

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US consumers are now the most pessimistic they’ve been since November last year.

That might not sound like a long time, but it’s important to remember that in November 2005, the US south coast had just been ravaged by a string of lethal hurricanes - so it‘s not surprising Americans were feeling downbeat.

This year, there’s not much sign of hurricanes - though it’s early in the season yet. But consumers have good reason to be worried. Oil prices are nearly as high as they were after Katrina had just blown herself out, while fears of a US house price crash are hitting front pages across the developed world.

And yet while there’s hope that there will be no further interest rate hikes, stock markets are clinging onto gains. But the optimists on Wall Street should be just as worried as everyone else…

Things aren’t looking good for the US economy. Even The Times’s generally optimistic American columnist Gerald Baker declared the US house price bubble well and truly over yesterday. And other commentators have been far more negative.

New York university economics professor Nouriel Roubini goes as far as to say that: “Every possible indicator of the housing sector that has been coming out in the last few weeks…suggests that the housing market is in free fall.” He reckons that “this may end up being the biggest housing bust in the last 75 years” - in other words, since the Great Depression.

US consumers have been relying on the housing market to fund their debt-fuelled spending. A housing bust of these proportions would be “enough to trigger a US recession…expect the great recession of 2007 to be much nastier, deeper and more protracted than the 2001 recession.”

But stock markets are still hoping against hope that the Federal Reserve will pull a rabbit out of its hat, just as Alan Greenspan always seemed to do. Although the consumer confidence data battered US markets in early trading yesterday, the Dow and the S&P 500 both closed higher. The mood swing came after minutes from this month’s Fed meeting showed that the bankers decided to keep rates on hold because they expect US economic growth to slow down.

The trouble is that the way Greenspan kept the US economy afloat after the tech bubble burst was by inflating a newer, bigger bubble, the US housing bubble. But now that the US housing bubble is bursting, it’s hard to see how you could find another, bigger bubble to cushion the impact - after all, there are few other assets that are owned by such a significant portion of the population.

Besides, the US is now facing rising inflation, which makes the interest rate decision a much tougher call than in Greenspan’s day. The Fed minutes also indicated that the bankers are keeping their options open, and many still believe further rate hikes will be needed. In fact, Mr Bernanke’s fellow central bankers are among those who think that the Fed is going too soft on inflation.

The Bank of England’s own Charles Bean had a dig at US monetary policy at the central bankers’ annual trip to Jackson Hole in the States over the weekend. He argued - much as we do here at Money Week - that using core inflation, which excludes fuel and food costs, makes no sense and understates the real rise in living costs. The Fed of course is fond of this core measure for that very reason.

But Mr Bean points out that high oil prices are at least in part due to rising demand from China. One of the reasons that Chinese demand is rising is because the Chinese are building so many factories, which then produce cheap goods, which they then ship back to the West, and the US in particular.

On the one hand, these cheap goods push down inflation. On the other hand, Chinese demand is pushing up fuel costs. One goes hand in hand with the other. But the ‘core’ inflation measure conveniently ignores the higher fuel prices, but includes the lower consumer goods prices, giving a measure of inflation that is ‘lop-sided’, as Martin Hutchinson puts it on Breakingviews.com. And that means interest rates are set too low. This is obvious when you look at real interest rates, which are adjusted for inflation. US real rates are sitting at just 0.5% in the States, if you use the headline inflation rate of 4.8% rather than the core rate of 3.1%. That compares to 2.35% in the UK.

It’s not surprising that Mr Bean is annoyed. According to Credit Suisse, the US is responsible for the pick-up in global inflation since 2002. “US domestic price pressures are threatening to put an end to a global disinflationary process that has been a constant trend in the global economy since the ‘90s.”

In other words, by going easy on the rate hikes, the US is making other central bankers‘ jobs harder. “An overly accommodative Fed has flooded the world with dollars,” adds Martin Hutchison. “That makes it more difficult for other central bankers to control inflation; interest rates have to rise further and economic activity is choked off.”

With the inflation threat much greater now, it will be far harder for the US to justify cutting interest rates to see off recession, without foreign holders of US dollars concluding that the country is just trying to inflate its way out of its debts.

To be fair to Mr Bernanke, it’s not entirely his fault - he‘s in trouble whatever he does with interest rates. The seeds for the 2007 recession were sown a long time ago, under his predecessor, the man some called the ‘Maestro‘. We reckon that posterity will come up with a few more, less flattering names for Mr Greenspan once the housing bubble has detonated.

In a recent issue of MoneyWeek, Bill Bonner wrote about Mr Bernanke’s impossible balancing act and how the US slump could play out. Subscribers can read the piece online here:Why Ben Bernanke's balancing act will fail

Turning to the wider markets…
http://www.moneyweek.com/file/17452/the-us-housing-bubble-has-popped---what-now.html