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Ambrose Evans-Pritchard: Bernanke fears economy will hit brick wall
By Ambrose Evans-Pritchard
The Telegraph, London
Monday, August 20, 2007
Two days before the Federal Reserve stunned markets with a cut in the Discount Rate, governor William Poole said that nothing short of "calamity" would cause the bank to make an unscheduled change in policy. So do we now face calamity, or was Mr Poole being flippant?
All we know is that Japan's Nikkei index crashed 5.4pc overnight on Friday, and that the US commercial paper market seized up last week as borrowers failed to roll over $91 billion (£46 billion) in short-term loans.
We have hints that the request for the rate cut came from the San Francisco branch, so watch out for bank distress on the West Coast during the next few days.
The Fed explained that "downside risks to growth have increased appreciably," the first admission of anything amiss since the collapse of two Bear Stearns hedge funds set off the credit crunch in late May.
We can presume that Ben Bernanke did not undertake this volte face lightly, given his determination to end the Greenspan practice of reflexive bailouts -- and to shake off his own image as an easy-money man. I suspect Mr Bernanke now fears the economy is hurtling into a brick wall.
Beware the relief rally on Friday. World bourses fell for nine days after Greenspan cut interest rates in September 1998 to rescue Long Term Capital Management. The S&P 500 dropped 19pc and London's FTSE-100 fell 25 percent before that storm passed.
The LTCM crisis was a liquidity crunch. It occurred when the "China effect" was pushing down the price of manufactured goods, allowing central banks to slash rates without fear of inflation.
We are in a more dangerous world now. Stagflation lurks and debt leverage is frightening.
America is sliding into the worst housing slump since the Depression. The median price of new homes has dropped from $262,600 in March to $237,900 in June, down nearly 10 percent (Commerce Department). The overhang of unsold homes is 7.8 months' supply. The Case-Shiller index of 10 major cities showed a drop of 3.4 percent for all houses in the year to May, with falls of 11.1 percent in Detroit and 7 percent in San Diego. The market has yet to absorb the shock of 2 million adjustable mortgages with "teaser" rates being reset upwards by 35 percent over coming months.
The bond markets know the fuse is already lit on mass default, which is why $2,000 billion of US sub-prime and Alt-A debt packaged as securities is being marked down so violently on books -- German, French, and Dutch books as it turns out.
The hit to the real economy will follow soon. Americans now face wealth deflation on both the housing and equity markets. The savings rate is negative for the first time since 1934, leaving no cushion. The game of drawing down home equity to pay bills -- 6 percent of GDP at the height of the bubble -- is finished.
Consumers are wilting.
Look at the profit warnings from Wal-Mart, Home Depot, and Macy's. July car sales were the lowest in nine years -- not surprising, since the credit crunch has engulfed auto loans.
A perk of my job is receiving the daily intelligence briefs of the great City trading houses. With few exceptions, they insist that Europe and Asia are strong enough to pick up the growth baton as America slows, while the Brics (Brazil, Russia, India, China) will roar onwards with a vigour that extends this business cycle beyond the old textbook limits.
This "happy handover" is looking ever more suspect. The eurozone slowed sharply to 0.3 percent in the second quarter. Italy is slipping towards recession. French house prices fell 1.5 percent in July and Spain's construction bubble is bursting.
As for China, it is now a net drain on global demand (outside its borders). Imports have been flat for four months -- excluding a July jump caused by strategic stockpiling of oil. Yet exports are surging. The monthly trade surplus has reached $24 billion.
The top sources of extra stimulus to the world economy during the past two years have been the US, Spain (yes, Spain, the bubble king), and Britain, in that order. All three are debt addicts, running out of credit.
Watch Japan, still top creditor by far. Growth slumped to 0.1 percent in the second quarter. Retail prices have fallen five months in a row. The yen has snapped back 9pc against the euro and sterling this month, as funds playing the yen "carry trade" unwind speculative positions. The deflationary vice may now tighten hard.
The total carry trade -- where hedge funds to housewives chase yield across the world, much of it borrowed at near-zero rates in Tokyo -- is now $1,200 billion. It has been the super-fuel for the global asset boom. We had a taste of reversal last week. Liquidation pummelled New Zealand, South Africa, Brazil, Turkey, Iceland, and indeed sterling. If and when rates come down in the West, yen reversal may accelerate and cause further havoc. Rate cuts may prove self-defeating at first.
In the end, the world's central banks can always reflate the markets -- if they are willing to tolerate the side-effects. The 1930s liquidity trap has been overtaken by new methods of stimulus, as Mr Bernanke made all too clear in his "helicopter" speech in November 2002. "The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost," he said.
The Fed can "expand the menu of assets that it buys," he said, citing agency mortgage debt, a gamut of bonds, and even use of "commercial paper" as collateral. The process began gingerly last week. The markets may come to know real fear before it is finished.
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