Economic outlook

Had a nice talk around the fire last night with among others an institutional investor. He sees double-digit inflation ahead because of the weak dollar and commodity bubble. Here's an analysis from Morgan Stanley that sees three years of slower economic activity ahead.

How long and how deep will the current US recession be? How does the Fed’s monetary policy response compare to previous comparable episodes, and what has typically happened to inflation during such periods? While history never repeats itself, it often rhymes. That’s why we examine not only the past four US recessions (1975, 1981, 1990 and 2001) but also five big bank-centred financial crises that occurred in other countries during the past 30 years (Spain 1977, Norway 1987, Finland 1991, Sweden 1991 and Japan 1992) to help answer the questions above. We find some striking empirical similarities between the average US recession and the average of the five major banking and financial crises, but also some important differences. Whether this US recession will be more akin to the last few on its shores or to the Big Five foreign crises holds the key for risky asset prices. In either case, there is likely to be more pain ahead across the board.

The Big Five and the Last Four. Our selection of the five big foreign banking and financial crises is based on the analysis in a recent paper by Reinhart and Rogoff (see Carmen Reinhart and Kenneth Rogoff’s Is the 2007 Sub-Prime Financial Crisis so Different? An International Historical Comparison, NBER Working Paper 13761, January 2008). Their Big Five crises are all protracted large-scale financial crises that were associated with major declines in economic performance for an extended period in the respective countries. All of them left deep marks, with the Japanese ‘lost decade’ being the worst of the five. Our rationale for using the Big Five as a benchmark for comparison in addition to the past four US recessions is that, like the current US crisis, the Big Five financial crises were all preceded by a significant run-up in house prices, followed by a significant decline. Reinhart and Rogoff also show that the run-up in US house prices prior to the current recession was even larger than in the average Big Five crisis.

The average recession during the Big Five crises lasted two years, while the Last Four US recessions on average lasted only about half that time. The typical Big Five recession was much deeper than the average US recession.