Since 1982, credit expansion has supported the gains in both consumer spending and business investment. Financing the federal deficit has also been eased by capital inflows from abroad. Yet over the last year we have witnessed a change in the willingness of investors to supply credit at the narrow credit spreads experienced during the 2002-2006 period. The issue before us remains how much will credit spreads adjust to the new balance of risk and reward in this global economy? E. Silvia, Ph.D. Chief Economist, Wachovia
Neither the Great Depression Nor Japan
Stephen Roach, Head Economist, Morgan Stanley
Our base case for the global economy remains pretty grim. We think that this first synchronised recession in the advanced economies in more than 50 years will last at least until mid-2009, and emerging economies are slowing very sharply, too. Headline inflation is likely to turn negative in the US and in the UK (on the RPI measure) next year and looks set to fall below target in the euro area. However, we continue to look for an anaemic recovery to set in during 2H09 and 2010, and we do not believe that we will see a multi-year period of deflation. Yet, bearish investors are increasingly questioning our base case. Comparisons with Japan’s ‘lost decade’ of the 1990s or even the Great Depression of the 1930s have become quite popular. Given the size of the shock to the financial sector and the recent sharp deterioration of economic indicators, this is understandable. However, there are a few important reasons why we think that things will turn out to be neither as bad as in the Great Depression nor in the milder version of a depression that played out in Japan in the 1990s. Full Story Spectre of Deflation Moves Closer Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank The prospect of a significant downturn in global economic growth has prompted sharp falls in commodity prices, which are now feeding through into consumer prices. The October inflation numbers published in the past week showed a fall of 1.0 % m/m, the largest monthly decline ever, driven by a large drop in energy prices. More interestingly, though, core inflation, ie, consumer prices net of food and energy, also declined, down by 0.1% on the month. Deflation does not occur in an economy just because the price of a single group of goods, such as energy, declines. For deflation to be present, the price of a broad selection of goods needs to decline. In other words, core inflation and inflation expectations have to come down too. Although we expect inflation to continue declining in 2009, we do not expect to see a sustained period of deflation. That said, the concern about deflation is understandable, since the economic consequences of a deflationary environment are very negative. As falling prices increase the cost of debt, households and businesses will have an incentive to reduce debt levels, which in turn will weigh on consumer and corporate spending. Saving, on the other hand, becomes more attractive in a deflationary environment, and businesses and consumers will be tempted to put off investment or purchases of consumer goods. Hence, we could end up in a deflationary-recessionary spiral, which historically has proven difficult to stop. Full Story Secular Turn in the Credit Cycle? E. Silvia, Ph.D. Chief Economist, Wachovia
Full Story
Spectre of Deflation Moves Closer
Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank
The prospect of a significant downturn in global economic growth has prompted sharp falls in commodity prices, which are now feeding through into consumer prices. The October inflation numbers published in the past week showed a fall of 1.0 % m/m, the largest monthly decline ever, driven by a large drop in energy prices. More interestingly, though, core inflation, ie, consumer prices net of food and energy, also declined, down by 0.1% on the month. Deflation does not occur in an economy just because the price of a single group of goods, such as energy, declines. For deflation to be present, the price of a broad selection of goods needs to decline. In other words, core inflation and inflation expectations have to come down too. Although we expect inflation to continue declining in 2009, we do not expect to see a sustained period of deflation. That said, the concern about deflation is understandable, since the economic consequences of a deflationary environment are very negative. As falling prices increase the cost of debt, households and businesses will have an incentive to reduce debt levels, which in turn will weigh on consumer and corporate spending. Saving, on the other hand, becomes more attractive in a deflationary environment, and businesses and consumers will be tempted to put off investment or purchases of consumer goods. Hence, we could end up in a deflationary-recessionary spiral, which historically has proven difficult to stop.
Secular Turn in the Credit Cycle?
E. Silvia, Ph.D. Chief Economist, Wachovia
Since 1982, credit expansion has supported the gains in both consumer spending and business investment. Financing the federal deficit has also been eased by capital inflows from abroad. Yet over the last year we have witnessed a change in the willingness of investors to supply credit at the narrow credit spreads experienced during the 2002-2006 period. The issue before us remains how much will credit spreads adjust to the new balance of risk and reward in this global economy? As a follow-on, the new risk/reward balance will also set the pace for credit-financed growth in the economic recovery ahead. With investors now focused on risk avoidance, the consequent deleveraging of the American financial system suggests that economic growth will remain sub-par next year and therefore we expect the Fed will keep the funds rate below one percent all year. Risk avoidance will also bias long Treasury rates to remain below what might be considered equilibrium as the flight to quality dominates investor thinking.
Manic Depression
Steve Chan, Economist, TD Bank Financial Group
In this environment, the Fed knows what they want but they just don’t know how to go about getting it. Inflation worries are out the window, and in fact, the Fed now appears to be turning its attention to creating inflation. While the Fed’s target for the fed funds rate remains at 1.00%, the effective fed funds rate has actually been trading at below 0.50% since late October. On top of that, the Fed has quietly increased the size of their balance sheet by almost $1.3 trillion over the last two months. The Fed now has over $2 trillion to deploy into financial markets as needed. At the same time, with short-term market interest rates so low and the Federal Reserve paying 1% on reserves that the banks choose to park with the Fed, excess reserves in the banking sector have increased by $600 billion over the last two months – more than they hold in deposits – and almost $300 billion in just the last two weeks. This increase in bank reserves is a double-edged sword. On the one hand, it means there is a lot of cash sitting with banks that could be quickly deployed at a moments notice, rapidly increasing inflation and lending. Unfortunately, holding all these excess reserves means they are not currently lending it, implying credit markets are still too rough for to comfortably enter.
How Low Can Sterling Go?
Trevor Williams, Chief Economist at Lloyds TSB Financial Markets
Sterling has fallen sharply in the past year, down by 20% on the trade-weighted index. The fall against the dollar and the euro has been as deep or deeper, with depreciation of 29% and 16%, respectively. What is going on and how low can sterling go against the dollar and the euro, and what would be the implication for price inflation and hence for monetary policy? In the past, sterling declines of this order would lead to rising price inflation (see chart a) and a subsequent rise in interest rates that would weaken the economy and so help to keep inflation in check, but the Bank of England's view is that inflation will remain low this time. The reasons are that the economy is in recession, making it very difficult for price rises to be passed on by firms (though this may mean profits fall and so unemployment ends up being higher), commodity prices are now falling after rising to record highs in mid 2008 and, crucially, wage inflation is receding, as unemployment rises and employment prospects dim.
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