Friday, October 31, 2008

Forecasts for US Economy

Readers Question: A Few years back when US cut interest rates drastically to recover the economy from dot com bust, it leads to a boom in the housing market and created another bust. Currently US has cut the interest rates again drastically to 1%, wouldn’t it create another boom and bust? Thank you.

Graph of US Interest Rates

It is a very good question.

Firstly, you are right that the cut in interest rates did facilitate a boom in house prices in the period 2002-2006. This boom in house prices came to an end in 2006, and as house prices fell in 2007-08, the negative wealth effect pushed the economy into recession.

Boom and Bust 2001-08

  • The dotcom bubble burst in 2000-01, also the events of 9/11 left the US facing a serious downturn.
  • The Fed acted decisively to cut interest rates to 1%. This helped the economy avoid a serious downturn and the economy soon recovered. Many praised Alan Greenspan for his decisive action to avert recession, during a real crisis for America.
  • However, look how long interest rates were kept at 1% - until the end of 2004.
  • Because interest rates were so low. Buying a house was really attractive. Rising house prices and interest rates of 1%, encouraged US mortgage companies to offer a mortgage to every Tom, Dick and Harry. (better known as subprime mortgages).
  • Rising House Prices also caused a boom in new house builds.
  • However, by 2005, the Fed started to respond to rising inflation and a booming economy. Interest rates were increased to 5.5% by 2006. (See: Boom and Bust in US Housing Market)
  • This increase in interest rates meant that many who took out mortgages at 1% couldn't pay the mortgage back. They defaulted causing losses to the bank, and the financial crisis we see today.

Will A Boom and Bust Happen Again?

Now we have seen interest rates cut back to 1%, could we be in for another rollercoaster? - another boom and bust?
  • It could happen. People soon forget busts. Boom and busts occur with a certain regularity.
  • Behavioural economists note how often people engage in herding behaviour. (if asset prices are going up, everyone jumps on bandwagon. When asset prices fall, everyone sells)
  • You could argue that the financial bailout of the banks encourages moral hazard. i.e. the banks have lost billions but, they can rely on the taxpayer to bail them out.
Why It Might Not Happen
  • The boom in house prices was not just caused by low interest rates. It was also caused by irresponsible lending by subprime mortgage companies. I cannot see this kind of mortgage lending returning for the foreseeable future. One assumes the US has instigated better legislation for checking the suitability of mortgage lending.
  • Low Interest rates are not encouraging spending. The economic downturn is so serious, US consumer spending fell at an annual rate of 3%. This is a serious decline. Even in the recession of 2001, consumer spending didn't fall. The US, like Japan in the 90s, could see a liquidity trap - where lower interest rates fail to encourage people to spend.
  • The pain of falling house prices will take a long time to be removed from national psyche.
  • The problem was not that interest rates were cut to 1%. The problem is that they stayed at 1% for too long. Of course, it is easy in hindsight to say this. But, the Federal Reserve and Bank of England will need to be more careful in avoiding the same mistake. Also, the Federal Reserve and Bank of England need to give greater weighting to asset prices and not just focus on inflation.
Boom and Busts are inevitable in some form. However, there are definite lessons we can learn from the past decade which will help minimise the risk of future booms and busts. At the moment, the economic downturn is so serious, the idea of economic boom seems hard to grasp. But, when the economy recovers in 2009 and 2010, it is essential that policy makers learn from the mistakes of the past decade. This is not just for monetary policy but also regulation of the financial system.

1 comment:

Raghu said...

I came from DBT Blogging Idol 2. Wanted to wish you luck. Lets see how much more readers we can reach out in one month.