US house prices continue to lift, despite the increase in some lending rates in recent months as the bond bear market has taken hold at the prospect of the start of a monetary policy tightening cycle.
The reflation of the previously depressed housing market is yet another sign of a steady improvement in economic conditions in the US and will no doubt feed into the debate about when quantitative easing will start to be scaled back. Adding to the run of generally positive news was an unexpected rise in the index of consumer sentiment, which rose to a level a touch below a fresh five-year high.
The Case-Schiller index of house prices rose 0.9 per cent in June to be 12.1 per cent above the level of a year earlier. Since the trough in house prices early in 2012, house prices are now up 19 per cent, a decent rise that will not only restore confidence for owners of housing, but will continue to repair the balance sheet of the banks and holders of mortgage backed securities who were hard hit when the house price bubble burst in 2006. It should be noted that between mid 2006 and early 2012, house prices fell around 38 per cent, which puts the recent rebound into some context.
Clearly, monetary policy works. Easy money in the form of low interest rates and extra liquidity in the banking system have gained traction in the real economy. This reflation of the economy has been the aim of the Fed and it is increasingly clear it has dealt with the fallout from the Great Recession better than most economists and analysts predicted.
The gains in house prices in the US are another vital element in the Federal Reserve’s consideration of when and by how much to start winding back its quantitative easing. Most of the smart money is on the Fed signaling a baby step next month towards the start of a monetary policy tightening cycle, although the market ructions overnight which saw US stocks down around 1.5 per cent could get in the way of such an early move.
Just to clarify what a monetary policy tightening cycle is in the current context of the US economy – it means, first of all, a scaling back in the bond purchases by the Fed from the current $US85 billion ($94.10 billion) a month to something like $US75 billion a month, or a touch less.
If all goes well, once these first few baby steps have been taken the Fed is likely to continue that process of reducing the amount of bonds it buys each month until it reaches zero. Given the decent momentum in the US economy at this stage, it is likely that sometime around the middle of 2014 the bond buying program of the Fed will have ended.
After that, it gets even more interesting. The next leg of the monetary policy tightening will be either the tentative start of the Fed unwinding its bloated balance sheet – in other words, selling bonds into the market – or it will deliver a hike in the Fed funds interest rate, or some combination of the two.
Before getting too fearful about the prospect of the Fed selling bonds and hiking interest rates, such moves are unlikely to be evident until 2015 at the earliest. Even then, they will only occur if the US economy is steaming ahead at a 3 per cent plus growth pace, with the unemployment rate heading comfortably below 6 per cent and heading towards 5 per cent, and it will need to see the various inflation measures above 2 per cent. It will also be essential that financial markets are well behaved and able to cope with the withdrawal, however cautious, of the most stimulatory monetary policy the US has ever seen (Facing up to the Fed's moment of truth, August 22).
Already fiscal policy in the US is being tightened with a near record pace in the reduction in the budget deficit. This was a necessary move given the parlous position of government finances in the US.
Soon it will be the turn for monetary policy to start the process of normalising. Given the conditions that must be met for this to occur – namely, a sustained momentum in economic growth – it will be a lovely ‘problem’ to deal with.