The Hindu Business Line : Asset price stabilisation first priority

With interest rates already at near zero, the usual suspense ahead of the Federal Open Market Committee’s bi-monthly meeting was absent. But, as always, the post-meeting statement did engage the attention of markets.

Not that it contained any great surprise. For, that the economy is in recession is old news.

The inflation of just a few months ago is now close to zero and could soon turn into deflation. This is ‘bad’ deflation — prices falling because demand is falling and not because of technology and productivity improvements. There’s no incentive to consume and invest today — for who would do that if prices are going to be lower tomorrow.

Deflation also means positive real interest rates amidst zero nominal rates. ‘Inflation targeting’ is turned upside down as central banks aim to create inflation instead of battling it.

It’s not that we need inflation in just goods and services. Of much more concern in the current environment is asset deflation. Banks’ and investors’ credit and investment exposures are not as much to manufacturing and business as to property through mortgage-backed securities and their first and second order derivatives. With house prices in a never-ending (and apparently) free fall, it’s no surprise that banks’ losses seem to be a black hole.

The Obama administration’s mantra is to make banks lend. To achieve this, banks are being recapitalised on a massive scale. Is it barking up the wrong tree? Why would banks not lend if there are opportunities? Obviously, there are fears of inability to repay if borrowers lose jobs and incomes. And a big question mark still hangs on the behaviour of house prices.

The US banking system (or at least its most important institutions) is de facto nationalised. If Government goes further and takes over their management, it can enforce its will on lending. But, that will not remove the attendant risks. In this context, Government’s and the Fed’s tasks are clear — stop the haemorrhaging of house prices. This will involve an extensive programme of restructuring the mortgage debt of households and the mortgage debt portfolios of banks. Houses at the risk of or facing foreclosure must be taken out of the market as they act as a significant depressing influence and prices.

What is needed, in short, is asset inflation. Obama could announce a goal of stabilising house prices. It cannot be worse than the many unorthodox measures — financing non-Treasury collateral, buying commercial paper, infusing public money into banks, guaranteeing loans to businesses — that governments and central banks have been forced to resort to in recent times.

Once bitten, twice shy. Lenders and investors rightly see excessive risk. Changing such perceptions is essential if we are to get commerce and lending moving again.

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