Despite the credit crunch, an excess of demand means that a substantial further correction might still be necessary. If inflation takes hold, yields might fall again, as Richard Barkham reports
The economic outlook is not pretty. While inflation has replaced the credit crunch as the lead economics story, it is quite clear that the increased cost and reduced availability of credit across the OECD is substantially impeding economic growth. This seize-up in the banking sector has put housing markets in the US, UK, Spain and Ireland into free fall - literally. The knock-on downturn in consumer spending is only just beginning.
To compound matters, OECD policy-makers are bereft of the firepower to deal with the crisis. Externally generated inflation means that interest rates are more likely to rise than fall; fiscal deficits and falling tax revenues mean that governments cannot spend their way out of the crisis. What started as a sector-specific crisis within the banking industry is becoming a more generalised economic downturn.
Nor are the recent signs of stabilisation in the US economy of much comfort. Interest rates of 2% are hardly sustainable and a ‘double dip' recession is the most likely outcome. In fact, alongside the cyclical downturn, it increasingly feels that we are approaching the end of an era. Are we in for a decade or more of instability or, as always in the past 17 years, will central banks be able to get us out of this mess?
The overriding policy success of the past 16 years is the decline in inflation, not just in the UK and the US but across the OECD. As lower inflation expectations have become embedded across the OECD, so central banks have gained the ability to accommodate economic shocks without stoking up a wage price spiral.
The culmination of this policy flexibility came in the 2002-04 period in which OECD real interest rates were cut to zero to counteract the deflationary impact of the dot.com crash (figure 1). Four key factors have brought this about. First, across the OECD central banks have been freed from political interference. Although this is not a prerequisite of inflation targeting, it helps. Second, close attention to output gaps as opposed to monetary aggregates has allowed central banks to keep demand much closer to supply than previously. As such, inflation arising from tight labour markets has been much less of an issue.
Third, privatisation and labour market deregulation across much of the OECD mean that the second round effects of demand and supply shocks are much reduced. Fourth, the vast labour markets of the former communist world have been opened up to OECD capital (figure 2) allowing a massive reduction in the price of manufactured goods. While the relocation of manufacturing (and some services) activity to low-cost centres has been acknowledged there has been a tendency to think that this effect would last for ever.
Worryingly, the current inflation spike has not been predictable from the close observation of OECD output gaps. Although these have indicated that there is very little spare capacity, they have also shown that demand and supply are roughly in balance and prices should be about stable (figure 3). They clearly are not. It is becoming increasingly clear that OECD inflation depends not just on the OECD but the global output gap.
Breakneck growth in emerging markets has aggregate demand in the global economy to a point where it is above aggregate supply. As a result, raw materials prices are surging and emerging markets labour costs are also nudging upwards. In the sense that OECD policy-makers are finding it difficult to deal with this imported inflation, we are indeed at the end of an era.
What are the implications of this analysis? In the short term, even after a year of the credit crunch, the world economy faces excess demand. A substantial further slowdown is required. Unfortunately, both motivation and policy levers are inadequate in the emerging markets. To the extent that strong growth continues in these countries OECD nations will have to make a bigger, possibly recessionary, adjustment.
Having grown used to ever-rising prosperity, western voters will not like this. Potentially, central bank independence will come under question and pressure will build for interest rates to be set by ‘accountable' political leaders. Longer term, there is a need to bring emerging market policy-makers into the global policy-making fold. In a globalised world, policy needs to be globally coordinated.
Given the need of emerging market leaders to create wealth for their (still) poor populations this sort of coordinated policy-making seems unlikely. In fact, we may yet see some OECD nations actively trying to engineer a recession in emerging markets through trade barriers or aggressive devaluation.
How does all of this affcct real estate? If policy-makers give in to voters and inflation becomes a daily reality then, after we have dusted off our arguments about real estate as an inflation hedge, we might see yields fall again in the medium term. But the lessons of the past 20 years have probably not been forgotten and the brakes will be placed on economic growth until inflation subsides. The era of easy inflation control is over and, the economic turbulence this will cause suggests that the substantial upward shift in the real estate risk premium currently taking place is long term in nature.