By Ian Campbell
Published 1/30/2004 3:13 PM
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These are perilous times for asset markets. As usual, the problem is not that they're going down but that they have kept going up.

These comments might seem out of place given that this week there have been some sharp falls in U.S. stocks. These began Tuesday afternoon, following the regular meeting of the U.S. Federal Reserve's Open Market Committee, which decides on the level of the short-term Fed funds interest rate. The Fed shook the markets not with an upward move in interest rates but with a change of wording in the terse statement with which it disseminates its view.

The change was akin to a "Spot the Difference" competition for economists.

"The committee believes it can be patient in removing its policy accommodation," the Fed wrote, whereas previously it had said "policy accommodation can be maintained for a considerable period." A small difference but a market moving one.

The extent of the fall showed how important has been the assurance given by Federal Reserve Chairman Alan Greenspan that interest rates would stay low for a very long time. No unpleasant surprises, was Greenspan's message. Cheap money forever! Or almost forever. But some members of the Fed's Board of Governors were rumored to be uneasy about this commitment. What if the Fed in coming months were to see a need to put rates up?

That the Fed has changed its wording now, however, may be as much as anything a sign of confidence. Things have been going Alan's way. U.S. stock markets are close to two year highs. GDP growth was 8.2 percent in the third quarter (and 4.0 percent in the fourth; as we learned Friday). Bond yields are low so that, according to the Mortgage Bankers Association, the average rate for a 30-year fixed rate mortgage in the week ending January 23 was just 5.58 percent.

These very low mortgage rates are, for now, Greenspan's great achievement. In time, they may prove his greatest disaster. The Fed has no direct control on long rates, Greenspan's skill has been to bring them about with carefully worded comment. And so we have the extraordinary combination of a 1 percent short-term interest rate, less than the annual inflation rate of 1.9 percent, and quite high GDP growth--a combination that would normally be thought inflationary and dangerous to long-term lenders. Yet the yields on bonds are very low and it is cheap to borrow funds long-term.

Alan! You can talk us into anything!

But there is another factor, too, behind the current extraordinarily low long-term interest rates: the lack of any real sign of higher inflation--despite high prices for oil and natural and some other commodities--and the fear of deflation. Excluding volatile food and energy costs, U.S. inflation was only 1.1 percent in 2003, less than half the 2.3 percent average annual rate in the previous seven years.

It is deflation that Alan fears, we would guess, which is why his monetary policy has been so extraordinarily loose. And with what is he fighting deflation? Inflation. In asset prices.

This week the National Association of Realtors revealed that in 2003 sales of existing single family homes rose to 6.1 million in 2003, breaking the all-time previous record of 5.57 million by a good margin. When was the previous record set? You've guessed it. In 2002. Just as with the stock market in the late 1990s, record builds on record.

All the house-buying activity has had a big impact on prices. "For all of 2003, the median price was $169,900, up 7.5 percent from a median of $158,100 in 2002," the NAR reports. "This is the strongest annual increase since 1980 when the median price rose 11.7 percent."

But in 1980 average consumer price inflation was 13.5 percent. House prices therefore rose in that year by less than the average inflation rate and by less than incomes. That is not the case at the moment. In an environment of low inflation and modest wage increases, house prices keep pushing up. In real terms houses are becoming more and more expensive.

Does this matter? It certainly matters for growth, because refinancing of mortgages has fed cash into consumption, especially of big-ticket items such as cars. And when you are buying a new house, what else do you do, but buy carpets, curtains, furniture, etc. A regular reader of these columns tells me demand for his product, used in the backing for carpets, has been booming.

The 2003 GDP figures released Friday show how consumption and government spending have been driving growth in the United States. Consumption spending rose by 3.1 percent in 2003, the same pace as overall GDP growth, but consumer spending on durable goods rose by 7.4 percent. Residential investment rose by 7.6 percent, contributing almost 0.4 percentage points of the overall 3.1 percent growth in the economy.

And while all this spending -- much of it mortgage financed--goes on, people are saving little. The personal savings rate in 2003, at just 1.5 percent of disposable income, is the second lowest figure ever recorded, well down on the already low rates of 2.3 percent recorded in 2001 and 2002.

The rising trend in house prices seems dangerous and unsustainable: a bubble, just like the rise in stock prices at the end of the 1990s. This trend, moreover, is not the only unsustainable, growth-funding trend in the U.S. economy. The fiscal deficit cannot keep going up.

What this means is that growth in the United States could easily tumble in the course of 2004. And asset prices, such as houses and stocks, which have risen fast in an economy in which overall inflation is unusually low, could tumble, too. They have risen on an unfailing diet of cheap money. History shows that bubbly money tends to get blown away.

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Global View is a weekly column reflecting on issues of importance for the global economy. Comments to icampbell@upi.com.