Fed Effects on Europe

Markets exaggerate in both directions. They create bubbles of overvaluation when expectations are high; they create troughs of undervaluation when expectations are low. At the present time, there is a struggle between optimism and pessimism, in which London is a good deal more optimistic than New York or Washington.

The Bank of England has published the latest issue of its twice-yearly Financial Stability Report. The Financial Times leads on the story under the optimistic heading “Bank of England Signals Worst Is Over.” The report’s argument was summarized by John Gieve, the deputy governor of the bank: “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months.” The bank’s optimism extends even to the U.S. housing market.

Even with a further decline in U.S. house prices, the bank does not expect any default in AAA-rated subprime mortgage-backed securities. That means that those securities are significantly undervalued and that some of the writing down has been much greater than necessary.

This optimistic review was published on the day that the Federal Reserve cut interest rates by a further quarter percentage point, to 2%. This was only slightly mitigated by the Fed’s hint that there might be a pause in rate cuts at the next meeting, in June.

There is now a very wide gap between the interest rate philosophy of European central banks, including the Bank of England, and the U.S. Federal Reserve. The Europeans have shown little willingness to counter the credit crunch by large and repeated interest rate cuts. The Fed has continued to follow the much-criticized Alan Greenspan policy of cutting rates early and often.

The pessimistic American view is supported by most New York opinion. Jim O’Neill, the chief economist of Goldman Sachs, says that Britain is “in the eye of the storm of a deleveraging world economy… The U.K. mortgage market is effectively frozen. House prices are going to go through negative changes. It’s going to be a challenge for U.K. policymakers.” This American view has even penetrated to the Bank of England’s Monetary Policy Committee, where an American member of the committee, David Blanchflower, has said that a 30% fall in house prices by 2010 is not implausible. Such a fall would be comparable to the fall in house prices in the United States.

My own view is that the Bank of England is probably premature in spotting a turn in the market. For some time yet, banks will be rewriting their capital bases. They will be concerned to reassure themselves and their customers about their own financial situation and will, therefore, remain risk averse and reluctant to lend. The banks have had a very nasty fright, in which it was impossible to value major investments and difficult to be sure of the true solvency position of major banks. That was a global phenomenon.

It may be true that the worst of the immediate panic has passed, but the mood of caution, even of exaggerated caution, has not. There are also, in the U.K., problems with the falling valuation of commercial property that are as worrying as the concerns about U.K. residential policy. The Bank of England wants to help restore confidence, but it will take time for banks to return to their more relaxed attitude to the lending risk. Indeed, the Bank of England would not want them to go back to the mood of 2006, when lending standards were too low.

However, the European view is not merely one of optimism about the future trend of asset values, but one of greater pessimism about inflation. Record prices for property may have peaked; some commodities, including gold, have reacted, as well. But energy and food prices are at record levels and have not yet turned down.

European bankers remain relatively anxious about the threat of a return to inflation. That is why European Central Bankers are reluctant to follow the Fed in cutting interest rates. The Bank of England is also worried about the rising budget deficit of the British government. High interest rates tend to offset the inflationary effect of the deficit, which itself seems to be rising by the day.

I find it easy to see the pessimistic case. I expect the U.K. housing and commercial property markets to continue to fall. In London, they are very closely linked. I expect the U.K. budget deficit to continue to rise. I expect Bank of England interest rate policy to remain cautious, as will that of the European Central Bank. I expect these financial conditions to continue in 2009, and probably 2010, as well. There is not all that much encouragement for optimism.

Regards,
Lord William Rees-Mogg
May 1, 2008