the times | Thursday April 28 2022 39

CommentBusiness

No safe places for investors to hide

as the Fed finally tackles inflation

Jay Powell, chairman

of the Federal Reserve,

faces a tricky balancing

act on interest rates

global economy has been hit by one

supply shock after another, from

pandemic disruption to supply chains,

to the war in Ukraine, to the latest

lockdowns in China, does not alter

the fact that in each case the impact

on prices is likely to prove a one-off.

What’s more, the global economy is

likely to cool, indeed already is

cooling, even without much

intervention so far from central

banks. Rising bond yields in

expectation of future rate rises feed

directly through to the economy in

the form of higher borrowing costs.

US 30-year mortgage rates, for

example, have risen to 5.37 per cent,

their highest level since 2009.

Meanwhile the cost of living crisis is

eating into consumer spending. In

that respect, inflation provides its

own cure.

That’s not to deny that there are

longer-term structural shifts arising

from deglobalisation that mean the

world may be heading towards an era

of higher inflation. The pandemic and

the war in Ukraine, along with the

associated sanctions, have forced

countries and businesses to reassess

the resilience of their economic

models. The result is likely to be a

drive towards greater self-sufficiency,

more vertical integration, shorter and

more diversified supply chains. All of

this is likely to lead to higher costs

and in the end to higher prices. The

next 30 years are therefore unlikely to

see a repeat of the past 30 when

globalisation put strong downward

pressure on prices, though these

trends will play out over many years.

That leaves the Fed facing a

difficult balancing act. For the

moment, the market seems to be

betting it will succeed in navigating

the narrow path between raising rates

too high and triggering a recession

and being too complacent, thereby

allowing inflation pressures to build

to a level where a prolonged period of

much higher rates is needed.

Remarkably, despite the sell-off in

shorter maturities, 30-year Treasuries

continue to yield less than 3 per cent,

notes David Bowers of Absolute

Strategy Research. But the risk of a

policy mistake remains high. If that

3 per cent level is breached, it will

signal that the world really has moved

into a new era. In

that case there may

not be many safe

places for investors

to hide.

You need to be

approaching your

sixties to remember

anything like it. The

benchmark ten-year

Treasury bond has so far fallen 14 per

cent in just eight months. The last

time the market suffered such a

drawdown was in 1987, the year of the

stock market crash and long before

most City traders began their careers.

The repercussions have been felt

across the fixed income markets.

Nearly $7 trillion has already been

wiped off the value of global bonds

from their all-time high in January

2021. For decades, bonds appeared to
      be a one-way bet. Prices soared and
      yields tumbled through the dotcom
      boom and bust, the global financial
      crisis and even the pandemic. Now
      the bubble appears to be bursting.
      Yet the bond market bloodbath so
      far could be the tip of the iceberg if
      some of the more pessimistic
      forecasts for the US and global
      economy are borne out. What has
      driven the latest sell-off has been a
      dramatic volte-face by the US Federal
      Reserve, which has had to admit that
      it spectacularly misjudged the
      inflation risk last year.
      It spent much of 2021 insisting that
      rising prices were “transitory” and
      that there was therefore no need to
      raise rates. It now accepts that US
      inflation, which hit a four-decade
      high of 8.5 per cent last month, is
      proving far more persistent than
      anticipated and is becoming
      embedded in business and consumer
      expectations, risking a 1970s-style
      spiral of rising wages and prices.
      But could the Fed be about to make
      as big a mistake overreacting to
      inflation now as it did by ignoring
      inflation for much of last year?
      Chairman Jay Powell signalled last
      week that the Fed is likely to raise
      its main policy rate, which
      stands at just 0.25 per cent,
      by 0.5 percentage points
      next week, the first of
      what is expected to be
      a series of half-point
      rises this year. The
      market is betting
      that there is a 50
      per cent chance the
      rate could hit 3.5 per

cent in 12 months, and the consensus

among forecasters is that there is a 28

per cent chance of a US recession in

the next 12 months. Meanwhile

Deutsche Bank is predicting that

rates will need to rise to 5-6 per cent,

enough to trigger a deep recession.

That wouldn’t just be disastrous for

bonds, it would be a bloodbath for

equities too. They have largely held

their own apart from vastly

overinflated tech stocks, which have

already crashed this year. A recession

would kill hopes of strong earnings

growth, which is the only thing now

supporting equity valuations given

that rising bond yields have made

current dividend yields look puny.

Rising bond yields would also bring

the risk of financial crises, which

historically have tended to coincide

with Fed tightening cycles. Already, as

this column noted last week, there are

signs of strain in emerging markets

where sovereign bond yields are

soaring, particularly in countries with

high levels of dollar-denominated

debt. Traders with long memories will

recall how rising US interest rates led

to the peso crisis and Mexico’s near-

bankruptcy in 1994-5.

Nonetheless, it is far from clear that

the kind of interest rate rises that the

market now fears may be coming are

in fact necessary. There’s no question

that at least some of the US inflation

is caused by the economy

overheating. The Fed’s decision to

keep rates low even as the Biden

administration unleashed a vast post-

pandemic fiscal stimulus on to an

economy that was already bouncing

back robustly from lockdowns led to

excess demand relative to supply. It is

also true that with unemployment

down to just 3.6 per cent, American

workers, like their counterparts in

Britain, are in a strong position to

demand higher wages. That

underscores the need for

the Fed to cool the

economy to

dampen demand.

Even so, it

remains the

case that much

of the inflation

is likely to

prove

transitory, as

the Fed, in

common with

other central

banks, surmised last

year. The fact that the

‘‘

’’

M

ichael Gove has

endorsed the idea of

building more social

housing. The housing

secretary wants to spur

private building by replacing

affordable housing requirements

and section 106 agreements with a

simple levy from developers to

councils. One way of countering

concern from charities about

eliminating such rules is to highlight

how local authorities could use the

revenues to build council houses.

It’s fashionable to blame Margaret

Thatcher’s right-to-buy scheme and

the failure to replenish council

housing stocks as a big cause of

sluggish homebuilding since the

1980s. A timeline implies that as the

state retreated from construction,

the market failed to fill the gap.

Today, some Tories even suggest

that an uncompetitive housebuilding

industry is actively withholding

permitted development. The obvious

solution to these “market failures”, if

true, is more government

housebuilding, rather than shelling

out more in housing benefits.

The conventional wisdom, though,

is faulty. After years of inducement,

annual private housing completions

ticked up to 130,000 per year in the

late 2010s, a number dwarfed by the

293,000 new homes completed in

1934 and 176,000 per year through

the 1960s. Historically, the market

sector had no trouble producing

plentiful housing when permitted. A

“market failure” thesis must

therefore explain what changed.

And, indeed, why it is more of a

problem here than in other nations.

Across 32 OECD countries, only the

Netherlands, Denmark and Austria

have a higher social housing share

than the UK. At 17 per cent, the

proportion of dwellings that are

council or housing association

owned here exceeds France (14 per

cent), Italy (4 per cent) and

Germany (3 per cent). All of them

have many more dwellings than us

relative to population.

We also lead the OECD in

subsidies. Our housing benefit and

allowance spending, at 1.4 per cent

of GDP, is more than double

Denmark, the next country. The

choice between benefit bills or

government-owned bricks is a false

dichotomy: we have plenty of both.

What explains the UK private

sector’s failure to build enough

homes, especially relative to other

countries? The answer is the

tightening noose of our planning

system. A decades-long failure to

make more land developable in

areas where people want to live has

led to supply being less responsive to

population and income growth. As

cities hit arbitrary boundaries

imposed by green belts, density

restrictions and Nimby groups,

completions declined relative to

population, with median house

prices doubling relative to earnings

in England, and tripling in London,

as incomes and the population grew.

Councils buying land at prices

inflated by artificial scarcity to offer

subsidised housing is no cure for this

underlying disease. Indeed, every

indicator screams that this is a

general supply problem. We have the

smallest floor space per household in

western Europe, the lowest housing

vacancy rate in the OECD and land

values that rocket when granted

planning permission. A concentrated

housebuilding sector with “land

banks” is a consequence, not a

cause, of these failures. Dwindling

developable land makes the planning

process costly and risky, which

favours big players over self-builders.

Conscious of rejections,

housebuilders tone down their

applications’ housing ambitions to

increase approval chances, while

setting aside approved land to ensure

workers and machines remain in

continual use. They are then accused

of withholding development, with

high approval rates said to prove

that planning is no constraint.

The truth is that high UK house

prices no more make the case for

state housebuilding than high food

prices would state-run farms. The

UK doesn’t lack social housing. It

fails to match housing demand with

supply because permitted land is too

scarce and development too

difficult. With backbench Tories

spiking green-belt reform and

neutering housing targets, Gove

wants more modest ways to boost

supply. But he should not follow the

misconception that poverty-

entrenching council homes are a

substitute for planning reform.

Ryan Bourne is R Evan Scharf chair

for the Public Understanding of

Economics at the Cato Institute and

author of the recent book Economics

in One Virus

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