Fed actions, housing slowdown continuing to contract U.S. economy.
An historical comparison to the U.S. economy in the late 1990s shows that the country's troubles may just be beginning, says Daniel C. North, chief economist at accounts receivable management service provider Euler Hermes ACI.
"The stock market and housing market bubbles, and their demises, show unsettling parallels," said North on March 27. "The stock market bubble, which the Fed burst in 2000, caused significant disruption and sent the economy into contraction for three years. The housing market bubble, which the Fed burst just a few months ago, shows all of the same characteristics, including strong evidence already that an economic contraction is upon us. If history is any guide, it is likely to get worse."
North demonstrated five steps that both incidents have had in common:
- Step 1: The Fed held monetary policy steady for some time before it started raising the Federal Funds interest rate to slow the economy and quell incipient inflation
- Step 2: The asset market continued its rapid ascent.
- Step 3: The Fed continued to raise the Fed Funds rate.
- Step 4: The market bubble popped and deflated, and the assets rapidly started to lose value.
- Step 5: For the stock market bubble, the economy quickly started to contract. For the housing market bubble, we are only beginning to see what is going to happen.
"To date, the housing market bubble has behaved exactly as the stock market bubble did in Steps 1 through 4," North commented. "If the housing market bubble continues on the stock market bubble's path into Step 5, we would expect to see conditions such as slowing GDP and job growth, as well as other negative indicators." Those expectations have already been met, he said, as job growth has been below the non-recessionary average for six of the past seven months. Additionally, GDP growth has been above the long-term average of 3.5% only twice in 10 quarters, and the last three quarters of 2006 were especially weak at 2.6%, 2.0%, and 2.2%.
Investors' fears regarding the housing slowdown's effect on consumer spending are valid, North said. "As of January 2007, asset value equivalent to 15% of GDP has disappeared from the housing market, significantly more than the 3.4% lost at this stage of the stock market bubble. This fall in value will not only cause defaults to rise and credit conditions to deteriorate, but it also will destroy some of the equity built in the past few years, equity that has fueled consumer spending.
"The consumer accounts for two-thirds of all economic activity, so a faltering consumer will surely lead to a faltering economy. On a more intuitive level, asset value equivalent to 15% of GDP simply cannot disappear without significantly affecting the economy," North added.
One other economic predictor is the U.S. Treasury yield curve, which remains inverted, "a condition that has been a perfect predictor of recessions for more than 30 years," said North. "The yield curve has been inverted for nine months and it seems unlikely to turn positive anytime soon. Simply put, the evidence is abundant that the slowdown that occurred in Step 5 of the stock market bubble is being repeated here."