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Wednesday, October 29, 2008


jpmorgan forecast: strong global recession, deflation

via brad setser and the ft -- nouriel roubini cites jpmorgan's newly slashed forecast.

This week instead this JP Morgan research group published its latest global economic outlook arguing that we are headed towards a global recession, negative global inflation and sharply lower policy rates in the US and advanced economies (a 180 degree turn from its previous position). As written in the most recent JP Morgan Global Data Watch:

A bad week in hell

Increasingly, the signs point to a deep and synchronized global recession. Today’s reported slide in UK 3Q08 GDP is expected to be followed by contractions in the United States (next week), the Euro area, and Japan—confirming that the global downturn began last quarter. More troubling is the additional loss of momentum at quarter end, combined with collapsing October survey readings. These developments appear to be part of a negative loop in which economic and financial weakness are feeding on each other, making the prospects for growth in the coming months decidedly grim. Once again we have taken an axe to near-term growth forecasts for the developed world and will likely follow up with additional downward revisions for emerging market economies in the coming weeks. Already, our forecasts suggest that global GDP will contract at a near 1% annual rate in 4Q08 and 1Q09.

It is still too early to accurately gauge the depth of the downturn, as the outlook depends on how well policy actions contain the financial crisis. From a US perspective, our current forecasts place the contraction in GDP somewhere between the last two mild recessions and the deep contractions of 1973-75 and 1981-82. This picture masks the degree to which the pain of the current downturn is falling on households. From the perspective of wealth losses and declines in real consumption, the current recession is likely to prove more severe than any of the previous ten in the post World War II era (see Special report: How deep is the ocean? Gauging US recession contours). For Western Europe, the current downturn is currently projected to look similar to the one in the early 1990s—the last episode in which regional GDP contracted…

Inflation and real policy rates to go negative

With part of this year’s slide in global growth linked to an inflation shock, the recent collapse in global commodity prices should be seen as an important factor cushioning the downturn. In the six months through August 2008, global consumer prices rose at a 5.6% annual rate, prompting stagnation in real consumption across the globe. Based on recent moves in the price of oil and other commodities, it is likely that the coming six months will see headline inflation dip below zero. While this swing will be a plus for consumers across the globe, it is also a development that will promote a significant growth rotation towards the G3 and Emerging Asian economies that were hurt most severely by this negative shock. In the developed world, this backdrop of contracting GDP, collapsing inflation, and financial market stress opens the door to a powerful monetary policy response.

consider that global growth of 3% or so is considered flatline, and a forecast of (-1%) represents one of the most severe global events of the postwar or indeed any era.

roubini also weighs in on the prospects of a policy-driven inflation:

So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question is: likely not.

First of all, the massive injection of liquidity in the financial system – literally trillions of dollars in the last few months – is not inflationary as it accommodating the demand for liquidity that the current financial crisis and investors’ panic has triggered. Thus, once the panic recede and this excess demand for liquidity shrink central banks can and will mop up all this excess liquidity that was created in the short run to satisfy the demand for liquidity and prevent a spike in interest rates.

Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized as opposed to being financed with a larger stock of public debt. As long as such deficits are financed with debt – rather than by running the printing presses – such fiscal costs will not be inflationary as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

Third, wouldn’t central banks be tempted to monetize these fiscal costs - rather than allow a mushrooming of public debt – and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view: even a relatively dovish Bernanke Fed cannot afford to let the inflation expectations genie out of the bottle via a monetization of the fiscal bailout costs; it cannot afford/be tempted to do that because if the inflation genie gets out of the bottle (with inflation rising from the low single digits to the high single digits or even into the double digits) the rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary policy tightening to bring back the inflation expectation genie into the bottle. And such Volcker-style disinflation would cause an ugly recession. Indeed, central banks have spent the last 20 years trying to establish and maintain their low inflation credibility; thus destroying such credibility as a way to reduce the direct costs of the fiscal bailout would be highly corrosive and destructive of the inflation credibility that they have worked so hard to achieve and maintain.

Fourth, inflation can reduce the real value of debts as long as it is unexpected and as long as debt is in the form of long-term nominal fixed rate liabilities. The trouble is that an attempt to increase inflation would not be unexpected and thus investors would write debt contracts to hedge themselves against such a risk if monetization of the fiscal deficits does occur. Also, in the US economy a lot of debts – of the government, of the banks, of the households – are not long term nominal fixed rate liabilities. They are rather shorter term, variable rates debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid re-pricing of such shorter term, variable rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long term nominal fixed rate form. I.e. you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long term nominal fixed rate claims) but you cannot fool all of the people all of the time. Thus, trying to inflict a capital levy on creditors and trying to provide a debt relief to debtors may not work as a lot of short term or variable rate debt will rapidly reprice to reflect the higher expected inflation.

short version -- if the united states had a high proportion of long-term fixed-rate debt, needing neither to refinance or access new borrowing, a "capital-levy" inflation might work. but it does not -- and in fact the government aspect of this duration issue is becoming moreso all the time, with treasury skewing recent issuance not to 10- and 30-year bonds but to the short end of the curve, where financing has been far less expensive to obtain. this is one of the most insightful analyses of the inflation-deflation debate i've yet seen, and puts a shot across the bow of marc faber, jim rogers and many others who expect that the united states will be forced to monetize at some point.

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