American Dream Optimism in Denial of Inflation and Slumping Economy

By: Peter_Schiff

In holding overnight rates steady at 2% this week, the Fed once again put forth its belief that despite a cascade of horrific financial data, the economy was likely to continue to grow slowly and that inflation would moderate.  Although wrong on both counts, this view is consistent with the relative optimism that prevails across the country. After nearly two decades of an uninterrupted consumption binge, most Americans simply refuse to believe that anything can seriously derail the American economy. It's a pleasant dream, but the wakeup call can't be too far off.

The benign outlook on inflation is rooted in the hope that a slowing economy will pop the commodities “bubble” and break the back of inflation. Despite these pronouncements, most rational observers understand that inflationary pressures are currently intensifying, not abating. Rising commodity prices are not the source of inflation, but merely the symptom of rampant monetary expansion from the Fed and other central bankers around the world.  By all indications, the liquidity injections are about to shift into a higher gear.  The recent housing bailout bill is the most inflationary legislation ever enacted and there is already talk of yet another economic “stimulus” bill.  The new money creation needed to finance these schemes, together with exploding federal budget deficits, will not only reverse the recent declines in commodity prices, but send other consumer prices soaring as well.

It is also worth noting that a slowing economy does not, by itself, bring prices down.  If it did prices in Zimbabwe would be falling. When combined with responsible monetary policy, a growing economy would tend to push prices lower (based on greater productivity and expanded supply).

As far as the economy avoiding a recession, the chances of that are fairly close to nil.  In fact, if the government reported legitimate GDP numbers, the recession that is already being felt on a gut level would finally be officially recognized.

One reason for the apparent optimism on the economy is the belief that the housing market is nearing a bottom. Every step down the housing abyss seems to convince more and more people that the bottom is in. Last week's Case/Shiller Home Price report, which showed that real estate prices have now returned to 2004 levels, is the latest piece of such “good” news.  In fact in a new national survey by real estate website Zillow found that 62 percent of U.S. homeowners believe that their home is worth as much or more than it was a year ago. Three-quarters of those surveyed expected that the value of their homes would rise or at least stay the same between now and early 2009. Talk about a field of dreams!

However, given the horrific fundamentals of the market, I would expect that before the market finds a real bottom, another four years of price increases will be similarly erased; leaving prices at 2000 levels or lower. Although this prognosis may seem dire, it is nonetheless reasonable when you consider the current supply/demand dynamics.

Despite the sentimental hope that homes are worth what they cost to build, or what the last buyer paid, in reality they are determined simply by supply and demand.  In this case the supply of homes on the market, and the number and motivation of potential home buyers.

First supply: In 2008 there are more vacant and “for sale” homes on the market than there have ever been. In the last few years, despite signs of a coming real estate bust, the nation's largest home builders kept building. As a result, hundreds of thousands of unwanted homes were added to the market. These homes, combined with the existing homes that underwater mortgage holders are desperate to sell, add up to unprecedented supply. Inventory at the current sales pace is approaching one year.

The demand side is even worse. In real estate, a buyer's expectations for future price gains and their ability to obtain a mortgage (with as little money down as possible) largely determines demand.  It is telling that the price increase optimism of current home owners does not extend to current home buyers.  Also, with lending standards finally being tightened, buyers do not have access to the cash to bid up prices. Many are taking advantage of a still attractive rental market to sit on the sidelines.

These dynamics are actually much worse than what were in place in the summer of 2000 when the home price boom was still in its opening innings.  All of the factors that were in place to push home prices up to unsustainable levels (unlimited lending, massive speculation, widespread belief in the indestructibility of home prices) are all gone. Prices will continue to fall until all the gains sparked by these forces have been erased.    

The reckless optimism displayed by the Fed and current homeowners has proven extremely resilient. But sooner or later reality must intrude. Once the wake up call sounds, the economic effects will be severe.  Once homeowners realize that their equity is gone, and not likely to return, what incentive will many have to continue making burdensome mortgage payments?   With a new wave of option ARMs about to reset, this Christmas it will be the mail, not the bells, that will be doing most of the jingling.

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By Peter Schiff
Euro Pacific Capital
http://www.europac.net/

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