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| Author: | Roger M. Kubarych, Henry Kaufman Adjunct Senior Fellow for International Economics and Finance |
|---|
May 8, 2006
Market Eye on Nikkei Financial
The arithmetic is painful. The average motor vehicle driven in the US (these days, most likely an SUV or a light truck, not a car) gets about 15 miles per gallon. It is driven about 12,000 miles a year. So it uses 800 gallons of gasoline. The average price of unleaded regular gasoline cost $2.24 at the end of February. Since then it has soared to $2.90. At today’s prices, average drivers will pay $2,330 to fuel that vehicle for a year, up from $1,790. Median after-tax income in the US is now about $28,000 per person. That $540 increase amounts to 1.9% of median personal disposable income.
The cumulative rise in energy prices since the end of 2004 is, of course, far greater. Not only have gasoline prices doubled—for an overall shock of $1,165 per driver or 4.1% of median disposable income. But Americans also have to pay much more to heat their homes, run their air conditioners, and cook their food.
So why hasn’t this energy shock caused a sustained slowdown in personal consumption expenditures?
The answer is simple: American consumers, on average, no longer save. The US personal savings rate turned negative last year, and it remains below zero today. Millions of Americans are borrowing to sustain their consumption. They have mostly been borrowing against the elevated values of their homes. As a result, mortgage debt has soared to 90% of disposable income, as compared to 60% a decade ago.
What has been happening to the price of homes in the US? They have begun to decline. The Census Bureau estimates that the average price of newly-built homes has fallen by 3.6% from a year ago and 6.5% from last September. The average price of existing homes peaked in August 2005, according to the National Association of Realtors (NAR), and has subsequently decreased by 3%.
Leading indicators of housing activity point to a further weakness ahead. Mortgage applications to purchase homes have fallen over 10% since the fourth quarter of 2005. The NAR’s Pending Home Sales index has declined by 9% since last August. The National Association of Home Builders Housing Market Index has fallen virtually every month since it peaked in June 2005, for a cumulative decline of 30%. Inventories of unsold homes are at twenty-year highs.
So the housing boom is ending. The four percentage-point rise in short-term interest rates, as the Federal Reserve tightened monetary policy over the past two years, plus the recent rise in yields in the bond market, has significantly increased the costs of financing a home. That is the major factor eroding the strength of the housing market.
But the energy price shock also plays a significant role. Higher gasoline prices are straining household budgets, especially of low- and middle-income families. Higher fuel prices, especially of natural gas, are raising the costs of heating homes. It would take a major easing in energy market conditions to relieve these burdens. Yet, there is good reason to believe that the full extent of the recent tautness in global oil and gas markets has not registered in product prices to the consumer. Gasoline prices are almost certain to rise during the peak summer driving season.
What are the implications for economic policy? Washington has no serious ideas of what to do, and most of the proposals we hear would do more harm than good.
As for the Fed, it has been struggling with the energy shock dilemma for decades. Higher energy prices threaten to spill over onto the prices of goods and services in general, thereby raising inflation risks. But because demand for energy is fairly unresponsive to price increases in the short-term, consumers are squeezed. That can stunt economic growth prospects. An even more restrictive monetary policy under such circumstances would increase the danger of an economic slowdown.
Where does the Bernanke Fed come out? It’s hard to say. In Congressional testimony on 27 th April, the new Fed Chairman noted that energy price increases were a burden on consumers. He also conceded that the housing market was losing momentum and would have to be carefully monitored. He left the clear message that a pause in Fed tightening was coming relatively soon. But after some press commentaries called his statement “dovish,” he backtracked, telling a TV news personality that the market had “misinterpreted” his remarks. So we will have to wait to find out what the Fed decides.
But the dilemma won’t go away. The combination of lower economic growth and higher inflation will be difficult for the US to avoid. As financial markets try to cope with a more difficult economic outlook, volatility is almost certain to rise in the coming months.
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