Stephen King: Another fight against recession is on the cards for the US Fed

In many ways, the US is the global economy - it accounts for 33 per cent of global output

Walking along an icy road in your brogues, your feet suddenly disappear from beneath you. You find yourself lying on your back, nursing a bruised head, feeling rather foolish and hoping you haven't suffered serious damage.

As you struggle back to your feet, you're not too sure whether you've broken any bones. In the initial aftermath of your fall, it's difficult to make an assessment of your injuries. Only later, after your bruises have colourfully appeared and your joints have seized up, are you able to decide whether you should be heading off to the casualty department of your local hospital.

The US economy may not have feelings but, nevertheless, it may have slipped up on a treacherously icy road. Until recently, the main concern in the States was the persistence of inflation. While that worry now seems to be fading, a new threat has emerged. The US economy, supposedly the locomotive behind rapid global economic expansion in recent years, is stuttering.

At first glance, this might seem a surprising conclusion. Growth in 2006 has been reasonable, many of the business surveys are indicating continued expansion (although the Philadelphia Fed business survey lurched downwards in sickening fashion last week) and the labour market hasn't really softened. But there are a few rather disturbing signs.

Of these, the most obvious relate to interest rates and the housing market. A few months ago, investors were convinced that the Federal Reserve would carry on raising interest rates throughout much of this year. Some still think there may be another 0.25 per cent increase before the year is out. The vast majority, though, now believe the Federal Reserve is done with monetary tightening.

The focus now is on the timing of the first rate cut. Already, the bond market has rallied, with 10-year Treasury yield dropping like a stone from 5.2 per cent earlier in the year to less than 4.6 per cent on Friday. To the extent that 10-year yields reflect the expected path for short-term interest rates over the next 10 years, this rally suggests that investors now believe the risk to the US economy is one of too little growth, not of too much inflation.

The housing market has hit a brick wall. At the beginning of the year, it was still booming. Nevertheless, there were the first signs that house prices might have stabilised after earlier substantial gains. Most housing indicators, though, are now in freefall. Housing starts and building permits have plunged, the inventory of unsold properties on the market has surged, and sales are drifting lower.

These developments are discouraging. The US housing market has played a pivotal role in the US economy's expansion in recent years. Like the UK and Australia before it, the US has depended on persistent gains in house prices to fuel robust consumer spending. As people feel richer, they want to spend more. As their houses rise in value, they are able to borrow more. By borrowing more, they make the economy stronger. House prices rise still further and the process repeats itself.

This leveraged dance is fine while it lasts. But all dancers, eventually, get tired. The first signs of tiredness came in 2004 and 2005, when headline US inflation began to rise. Most of this increase was associated with higher oil prices. At the time, the Federal Reserve chose to ignore this inflationary impetus, preferring to focus on better-behaved measures of core inflation, which exclude food and energy prices.

In my view, this was a mistake. I'm not alone. As Charlie Bean, the Bank of England's chief economist, put it at the Jackson Hole central banking symposium last month: "The fact that the rise in oil prices is the flip side of the globalisation shock to me renders highly suspect the practice of focusing on measures of core inflation that strip out energy prices while retaining the falling goods prices". Put another way, the Federal Reserve may have left monetary policy too loose for too long. House prices rose too far. Households borrowed too much.

When the Federal Reserve eventually acknowledged the build-up in inflationary pressures, it had no choice but to continue raising interest rates. Price stability was too great an achievement to be allowed to slip through the hands of a central bank. This additional monetary tightening now appears to have clobbered the housing market.

So far, economic weakness has not spread far beyond housing. While encouraging, I doubt the story ends there. We know that mortgage equity withdrawal (in effect, borrowing cheaply against the rising value of your house) has been a key driver of consumer spending in the US and, as such, falling house prices and a softening housing market should throw the process into reverse. Consumer spending should, therefore, slow down.

But will there be a soft landing or, instead, will the US end up with something a little less palatable? The British and Australian experiences over the past couple of years provide some interesting pointers. Both countries had overly inflated housing markets. Both housing markets subsided. Consumer spending slowed down abruptly. But there was no recession and, indeed, hardly any monetary response. They either had soft landings or, perhaps, no landings at all.

Might the US be able to pull off the same trick? Perhaps, but the US faces some bigger challenges. The US housing bubble has not been confined to prices and sales: it has also been a story about excessive residential construction, which is now turning tail.

There's no room - and no political appetite - for a major increase in public-sector housing projects of the kind that doubtless kept the UK going over the past couple of years.

The British and Australian housing markets weakened at a time when the global economy was doing very well, a combination of exuberance in the US and rapid expansion in China, India and other emerging markets. Australia, in particular, benefited from its status as a major commodity producer during a period in which commodity prices were soaring.

If the US slows down, the global economy won't be doing very well. In many ways, the US is the global economy. The US accounts for 33 per cent of global output. The UK and Australia, at 5 per cent and 1 per cent of global output, are minnows. So long as the US is booming, smaller economies can keep their heads above water. But who can keep the US's head above water? China and India may be growing quickly, but they're still too small and not sufficiently developed to provide the lifeboat that would be needed should the US slip up. Only the eurozone and Japan could play that role and neither would find it easy: with limited room for manoeuvre on policy, they could easily come unstuck in the light of a US slowdown, particularly if their currencies were to appreciate against an arthritic dollar.

It'll be some time before we'll know whether the US's slip on the ice is no more than a bit of a bruise or, instead, amounts to a series of broken bones. But the slip has most definitely occurred. Downswings are typically associated with signs of stress. On this occasion, those signs are coming from the housing market. As growth fades, the Federal Reserve will, once again, have to provide some monetary balm. Increasingly, 2007 looks as though it will be a year of interest rate cuts and bitten fingernails as Ben Bernanke and his colleagues at the Fed struggle to avoid another US recession.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com