Volume 58, Number 7 | February 18, 2011
The Chinese are tightening! The Chinese are tightening! True, it was not unexpected, but neither were the attacks on Lexington (my home town) and Concord. The colonists spent the winter stockpiling arms for a battle they knew would come. Even then, they knew that policy works with a long and variable lag. This week, the Chinese raised their reserve requirement another fifty basis points. They allowed the yuan to trade under 6.58 to the dollar for the first time, continuing a 5% appreciation. And, they once again tightened the rules on real estate investments, now requiring foreigners to have paid taxes for at least one year before qualifying to buy a residence. These moves come as businesses ramp up after the New Year’s holiday and despite temporarily better news on food inflation. Property prices continue to rise rapidly across China, and evidence of overheating was clear in coastal firms’ aggressive recruiting of workers returning home from vacation.
Further evidence that China is still running red hot despite the tightening so far is found in surging imports in January. Month on month – seasonally adjusted by McVean – imports exploded 18% as producers hoarded raw materials due to expectations of ever higher prices. Iron ore and copper led the parade, but materials of all kinds saw heavy demand. And, exports rose a sharp 13% as well, as buyers are also stocking up ahead of expected price increases. The net result was the first month of trade deficit since February 2004 and only the third in the past decade. The holidays likely were partially responsible for this anomaly, but China’s trade surplus was already narrowing in the fourth quarter of 2010 as rising raw material prices shift the benefit of the boom away from the factory floor. Chinese margins are being squeezed and producers are trying to pass along the impact, as reflected in the hefty 1.1% rise in January non-petroleum import prices for the US.
You Can’t Get Blood from a Stone
Unfortunately, the US is not in a position to absorb external price pressure. The US consumer simply does not have the income growth to pay more for foreign – or domestic — goods and services and maintain the moderate expansion in real GDP. The conflict can be seen in the disappointing retail sales data and the rising price pressure in the inflation pipeline. Though many analysts point to the pricing pipeline and see an inflation threat, we see these price increases as a tax hike that funnels buying power away from the consumer to sustain profits at producers – especially foreign producers. Unfortunately, those producers are not using the funds for capital investment and/or hiring – at least in the US – short circuiting cyclical dynamics and leaving the consumer as the economy’s weakest link. Bottom line, the entire US economy is in a margin squeeze with import prices rising faster than PPI and core PPI rising faster than core CPI.
A margin squeeze is not unusual at this phase of the economic cycle. After all, we are in the seventh quarter of positive real GDP growth since the trough in June 2009. The pattern of inflation in the pipeline from imported and crude materials to finished products is not that different from episodes in early 2004, late 2005, and even late 2009 – and still much less pronounced than in early 2008. The reason the first three episodes of price hikes did not turn into even stronger inflation, as in 2008, is that real growth simply could not stand up to the price increases. Consumers had to make choices and some producers got crowded out of the market cooling the price pressure. By 2008, the boom in China was lifting prices despite a slowdown in the US, and the crowding out here was severe enough to lead to recession – and the follow-on debt related crisis in which we are still mired.
The Missing Link
At its heart, the key lead indicator of the US business cycle is still housing – and that sector remains as dead as a doornail. Housing is so crucial to the US economy because it represents the largest and most leveraged investment decision made in the consumer sector. Travelling around the world, it is not hard to spot the primary difference between America and other countries – our much larger housing units, which in turn drive an economy focused on those homes. Bigger houses require more furniture, more appliances, and allow more storage of all kinds of goods. They are farther away from each other requiring more cars – and bigger ones to carry all the stuff. Since the advent of the GI bill and the housing of the returning WWII veterans, America has had a love affair with housing that is now deeply embedded in our culture and economy. Our banking system converted from a traditional business lending arrangement pre-WWII, to a funding source for housing after. The crisis in the specially regulated housing friendly S&L sector simply led to the expansion of Freddie and Fannie and a new government commitment to housing. Democrats loved it, Republicans loved it – America loved it, and now it is broken and we can’t get up.
It is investment which drives the business cycle. When investors decide to risk their money – or someone else’s – on a capital expenditure, it uses resources without providing immediate product. As a result, prices and profits rise in those industries benefiting from the bet. Those industries then reinvest their profits on risky ventures of their own and the cycle expands. Only when the investments begin to pay off, increasing supply, does the rise in prices and profits moderate. When the added supply from older investments is large enough to satisfy the excess demand created by new investments, prices fall narrowing margins and reducing investment at the end of the economic cycle. In dynamics like the housing of the baby boom, population growth kept the need for new investment high for several generations. But now, after a decade of overbuilding from 1998 through 2007, we have many millions too many dwelling units (at least three). Even at today’s depressed levels of construction, it is not clear that new starts do not exceed household formation. With the unemployment rate sticky and high, saving on rent or mortgage payments is the easiest way to cope. Regardless, even if household formation was back to a trend 1.1 million units a year, it would take beyond the 2016 Presidential cycle to clear the excess – under current policy.
Unfortunately, with the government strapped for cash and the housing sector traditionally one of the biggest beneficiaries of subsidies, policy looks to get a lot more anti-housing in the next few years. Dismantling or limiting the GSEs that subsidized home mortgage rates is a near certainty. Talk of removing, or at least curtailing further, the benefit of mortgage deductions is rampant in Washington. What few realize is that limiting mortgage deductions will also eliminate the benefit of property tax deductions, as many itemizers only due so due to the large mortgage deduction. Boosting the cost of housing finance by eliminating government subsidies may be the right thing to do – but it will leave housing prices under pressure until they have fallen to a market clearing price. A 1% rise in mortgage costs (from about 5%) is equal to roughly a 20% drop in the price of a home, since it is primarily the monthly payment (price * rate) that determines whether a buyer is interested. Since home equity is still the bedrock of the small banking system – and the small business community – in America, that does not bode well for strong or sustained growth.
In recent months, rent and home owner’s equivalent rent (an estimate of the rental value for owned homes) have been rising, adding to upward pressure on inflation. This largely measures the tightening of the housing market at the low end as homeowners squeezed out by foreclosure seek refuge. We expect that over time, as the foreclosed units make their way back onto the market – potentially as rentals, this trend will soften.
The real question is how to move these unoccupied units out of the banking system and into stronger hands, so that the market can find a real price from which to recover. Big businesses – who currently have all the money — do not traditionally participate in renting, particularly of single family homes. And, individual investors face discouraging passive activity loss rules which limit the tax advantages of getting into this game. The government really stacked the deck in favor of home buyers. We are not sure if the 100% expensing option in 2011 can be applied to rental housing, but it would be a step in the right direction. Buying a foreclosed property with 29.5 year depreciation and allowing it to be written off in a single year would attract money – and at a modest cost to the Treasury, which only loses the time value of the depreciation allowances at very low interest rates. Moreover, any money lost on individuals tax collections would likely be made up in reduced write-offs at the GSEs and banks. Bottom line, the government is on the hook for a lot of the cost of the housing bust anyway via the existing tax system. They need to focus on clarifying the real cost of housing, so that investors and the bankers that finance them can get back to making capital investments – in housing or elsewhere – that benefit economic growth. A failure to get this right quickly leaves the US more vulnerable to a downturn imposed by tightening foreign policy.