Fed revving the engine but banks on the brakes

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The strength of US retail sales in October may simply be storing up bigger problems for months ahead

Economics is a pretty strange subject. Sometimes, you get seemingly impossible combinations of events. It's a bit like staring into one of M C Escher's more imaginative artistic efforts. What initially seems entirely plausible begins to send your head spinning. Suddenly you realise you have been the victim of an elaborate illusion, something that cannot happen in reality.

Take America's recent experience. Unemployment is rising quickly. Consumer confidence has fallen rapidly. And so retail sales are bound to be in a state of collapse. Right? No, wrong. America's consumers dipped deeper into their pockets in October than on any previous occasion. Retail sales rose a massive 7.1 per cent on the month, dwarfing the 2.2 per cent decline seen in September. Retail sales are now up 7.5 per cent year-on-year (see first chart).

Is this good news? Well, it seems to turn economics on its head. Faced with mounting job losses, consumers have decided to go on a spending binge. To my mind, this doesn't seem like the most sensible of responses. Then again, economics is always full of these little surprises. Let's say the US story turns out to be sustainable. That could be good news for the UK too. Imagine it. One morning, you'll be looking through the business pages of your favourite newspaper and – as you choke over your croissant or cornflakes – the headlines will read "Unemployment increase paves way for consumer boom".

It's not the most likely of headlines, is it? So why are American consumers spending so much when they've had to put up with terrorist attacks, anthrax attacks and job losses? Tax cuts may have provided some benefit but, quite frankly, they're not big enough to explain anything like the full extent of October's sales increase. The true answer lies with incentive schemes, clever plans designed to persuade consumers to ratchet up their debt levels just at the point when they're at risk of losing their jobs.

The basic story is about cars and price wars. There are three strands. First, consumer demand in the US weakened earlier in the year, leaving the big car producers with excessively high inventories. Second, General Motors's cost structure is a lot lower than either Ford's or Chrysler's, giving it an incentive to slash prices in order to increase market share. Third, the price slashing – in effect, zero rate finance – has a sell-by date attached to it. Buy now and you get a massive discount. Buy in a couple of months' time and that discount may well have disappeared.

So, as a consumer, what should you do? Some consumers will do nothing. They're worried about their jobs and they're unlikely to take on board any more debt. But not everyone stops buying cars in recessions. For those who were planning to buy over the next few months, there's no time like the present. Why wait when, today, you can get a fantastic zero rate finance deal? And that's what's happened. Within the 7.1 per cent increase in retail sales in October, sales of cars rose a whopping 26.4 per cent.

Other things being equal, higher retail sales should imply greater GDP. But this is one of these occasions where other things are not equal – the kind of difficulty that sends the economics profession into collective hysteria. The problem is straightforward. If the increase in sales is met entirely through an increase in production, there will be a big positive effect on economic growth. If the increase in sales is met through a reduction in inventories, there will be no impact on economic growth at all.

October's 1.1 per cent decline in US industrial production gives you the answer. Within the overall numbers, production of cars and car parts was down 4.2 per cent. In other words, higher sales of cars in October were matched by lower inventories, not higher production. On that basis, the impact on GDP should be negligible.

What happens next? Let's assume that would-be car buyers have simply brought forward their purchases of cars. Let's also assume the zero finance deals eventually come to an end – after all, the car companies cannot keep haemorrhaging cash. That leaves a big problem. If the car purchases for the next, say, six months have been brought forward into October and November of this year, there's going to be a very big "black hole" for car demand as we enter the first half of next year. The net impact should be a substantial fall in consumer spending and a stabilisation of inventories after the earlier falls. Ultimately, all that's happened is that consumers have been bribed to take on the depreciating asset which had, previously, been the sole problem of the car companies themselves.

If there is some good news from this story, it's that consumers do seem to be responding to lower interest rates. Yet this observation jars with comments made on this side of the Atlantic by Sir Howard Davies, chairman of the Financial Services Authority, in a speech to the CBI last week. He suggested one of the main risks for the UK economy was a build-up of consumer debt. Against a background of rising jobless numbers, increasing debt could lead to greater default and, as a result, a risk to financial stability.

If these arguments are relevant for the UK, then they must surely be relevant for the US. Consumers may be happy to take on debt at the moment but their balance sheet position is going to deteriorate in coming months. Their assets – gleaming new cars – will quickly depreciate in value. Their liabilities – the interest free loans – may cost little to service but, if job losses increase further, the ability to pay off these loans will be severely curtailed. Thus, the strength of retail sales in October may simply be storing up bigger problems for the months ahead.

Meanwhile, although lower interest rates appear to be benefiting consumers in the short term, there are increasing signs the overall transmission mechanism of US monetary policy is working less well. In earlier columns, I have emphasised the lack of follow-through from rate cuts into either higher equities or a weaker dollar. Now, there is evidence to suggest the banking sector has been unwilling to pass on the full benefits of the Federal Reserve's rate cuts. My second chart shows the relationship between Fed funds and one particular component of the Fed's Senior Loan Officers' Survey. In the survey, banks are asked whether they have either tightened or loosened their lending terms to large and medium-sized companies. The higher the number on the chart, the greater the degree of tightening.

Back in the credit crunch days of the early 1990s, the Fed's rate cuts actually worked. As rates fell, so banks tightened their lending conditions less and less. Since the beginning of this year, interest rates have fallen even faster. Yet, despite these valiant efforts, banks have continued to pull in the reins on their lending activities. Interest rate cuts may have persuaded consumers to spend more in the short term but there are significant doubts about the overall effectiveness of monetary policy. In this post-bubble environment, it may simply be that, relative to earlier recessions, the monetary drugs don't work.

Stephen King is managing director of economics at HSBC.

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