So everything’s all right then? Uncle Sam has ridden to the rescue of Fannie Mae and Freddie Mac. US financial stocks have rebounded from last week’s nadir. Oil has fallen, taking some the heat off hard-pressed consumers. The US economy has managed, so far, to avoid sinking into recession.
But don’t get too comfortable. Fiscal and monetary stimulus—combined with a weak dollar—has provided a cushion to the real economy. And, a consequence of the mega-bailouts is a greater risk that inflation could get out of control.
Two big fundamental adjustments are needed. The first is house prices in those economies that went on the biggest binges: the US, the UK and Spain. In the US, prices are now down 17% from the peak. But to bring them down to their long-term trend, they may need to fall roughly the same again. In the UK and Spain, the drops have only just started.
Further house price falls will increase mortgage delinquencies. It will also cause consumers to tighten their belts.
The second big required adjustment is to the US current account deficit. The US cannot continue to keep borrowing from the rest of the world to finance consumption. The only way of squaring the circle is for the US to tighten its belt. And, if that’s not to be achieved through a recession, it will be brought about by several years of sub-par growth.
An avoidance of recession would clearly be good for the banks. It helps explain why the rash of results from the likes of Citigroup Inc. and Bank of America Corp. have surprised the market by not being too bad.
The deleveraging process under way will also probably be muted. Banks will still pull in their horns. And the contraction of credit will be a dampener on the real economy. But, under the muddle-through scenario, it might not be too bad.
This doesn’t mean the world economy has found its get-out-of-jail-free card. Strong growth and an excessive supply of credit led to high inflation almost everywhere. A sharp shock would have cured this. But a prolonged period of adjustment plus mega-bailouts risk stoking the inflationary fires.
Policymakers are waking up to the threat. Charles Plosser, president of the Philadelphia Federal Reserve, said that US interest rates should rise “sooner rather than later”.
But Plosser is on the hawkish extreme of the US Federal Reserve. Even if rates rise, it’s unlikely to be for a few months, and the increase may only be a minimal quarter of a percentage point to 2.25%. With inflation already running at double that level, monetary policy would still be very loose.
So yes, the worst may be over. But the economic pains aren’t and the inflationary trouble may just be beginning.