Hamish McRae: US house market still holds the key to the date of the recovery

Economic Life

The central banks pull the levers but is there anything attached at the other end?

The world is moving to a near-zero interest rate regime, something that by rights should give a huge monetary boost to demand. It is also in the early stages of a huge fiscal boost too, with the deficits of the US and UK moving towards 10 per cent of GDP, and with deficits in Europe and elsewhere of perhaps half that. The markets, however, are not encouraged (or at least not yet) and the experience of Japan in the 1990s would suggest they are right to be sceptical. So what is going to happen?

The starting point is to acknowledge that, just as we have never had such a sudden decline in interest rates, at least in peacetime, so too we have never had such a sudden collapse in consumer and business confidence. All cycles have their special characteristics, and the speed of the switch from asset inflation to asset deflation – and the consequent impact on confidence at every level – is perhaps the key feature of this cycle.

To catch some feeling for the universality of that switch, have a look at the graphs. US consumption has fallen off a cliff – you have to go back at least a generation to see anything like this, with consumption running something like 5 per cent down year-on-year. In Japan, the second-largest economy, demand for consumer durables has also collapsed. In the eurozone, retail sales are now sharply negative, while here in Britain the most shocking number is the collapse of the home loans market. The problem for existing borrowers may indeed be the price of a mortgage, but for new ones it is getting a mortgage at all. Finally, also in the UK, you can see how wages have slipped well below inflation. If we are in a job, we get poorer every month. And sadly there will be many people who do lose their jobs in the coming months, for virtually all industries are under great and increasing pressure.

So then you have to ask: what is the mechanism whereby cuts in interest rates will change this round? Were the home-loans mechanism working, it would be very easy to boost demand by cutting rates because the market was sensitive enough to feed any change in rates straight through to salary cheques. Some feed-through will take place now, and that will improve the cash position of a lot of households. But there will be some other families that will be hit because many will see their incomes decline. As a rule of thumb, it takes four or five savers for each borrower so, numerically, more individuals suffer from a fall in interest rates than those who benefit. Since the impact on savers is smaller than on borrowers, there is a net boost to demand – but we should not forget there are losers as well as gainers.

The longer-term impact of lower interest rates is on the willingness of people and companies to take on debt. But there are two reasons to be cautious about that. One is the oft-made point that, at the moment, the availability of credit is a greater limit on behaviour that its price. The other is that demand for loans matters as much as supply, and it may well be at the moment that the very low numbers of new mortgages being agreed is the result of people not wanting to buy a house now when they think it might cost 15 per cent less in a year's time. That is the rate at which house prices fell over the past year and, if anything, the fall seems to be speeding up.

But asset prices do not fall for ever. So the question seems to me to be at what level and at what time do global asset prices reach equilibrium? Until that happens, everyone is chasing their tails. Banks have to curb their lending because of the pressures on their balance sheets from bad or doubtful debts, backed by falling collateral. Companies have to trim their investment and their workforces because they have to cut their debts, in part because the assets against which they are borrowing are falling in price. Homeowners in Britain will continue to be cautious until the price of their principal asset, their home, stabilises. Until this asset deflation is out of the way, it is very hard to see a sustained global economic recovery.

Unfortunately, there is no ready-reckoner which we can flip out and use to calculate that by March 2010, say, global asset prices will have bottomed out and the recovery can begin. We don't know what markets are the most important, what their long-term equilibrium level is, whether the markets will overshoot on the downside – there are too many imponderables. What I think you can say, though, is that this global credit crisis started in the US housing market and that is the place to look for its conclusion. So when everyone can accept that houses in America are cheap, that will be a signal for confidence around the world to return. It won't be the only signal but it will be very important because it will make it possible for banks everywhere to be confident that all the bad news is out. They will then be able to start writing back some of the loan losses they have provided for because those losses will not be as bad as they had assumed.

And when might that be? My guess, although very unscientific, is that it will be not less than a year but not more than two. If that is right, then 2009 will be a horrid year, as most of us have been warning, but by the end of 2010 a global recovery should be assured.

Translate that to the UK and something pretty similar seems likely to happen here. Most of the forecasts suggest that the bottom in house prices will be reached some time in 2010, and if they continue to decline at the present rate that would place them well within their normal range relative to earnings. If the experience of the early 1990s is anything to go by, there will not be a sudden upward bounce then, though, because the economic recovery will be sluggish.

The economy will be held back in part by the fact that taxation will have to rise, and by the fact that there will still be a huge pile of personal debt hanging over consumers. Interest rates will also have to go up to claw back the swathes of liquidity that have been pumped into the markets by the central banks. But, in a way, I think it may be easier to see the timing of the cycle than its depth. Undoubtedly, economic demand is coming off very fast now but so too is inflation. If goods and services become cheaper, we will buy more of them and that will limit the depth of the bottom part of the cycle.

The scale of the expansionary policies of the main central banks and governments is so big that it must eventually have some effect, and I think is it is still possible, at least for Britain, that this downturn will not be any worse than that of the early 1990s. However, just as it took a long time for consumers around the world, including here, to lose confidence, it will equally take a long time for them to regain it.

Things won't go on going down for ever – but then they won't come up very fast again, either.