Yes, we Keynes

So here it is, the turn of the cycle. It is earlier than most expected and - somewhat ironically - it is occurring at a time when a string of forecasts has been published e.g. by the IMF, the EU Commission, research institutes and the German government that predict no real recovery until the second half of 2010.

Of course, the green shoots of recovery are still feeble. But they are becoming more numerous. The first indicator to improve after the fierce drop in demand was business expectations. Whether you look at the purchasing managers’ indices – with the very marked rebound for example in China – or other sentiment indicators like the ifo-Institute and the EU surveys, you can see that some confidence is returning in the corporate sector. The turnaround can also be seen in analysts’ economic expectations, in rising stock markets and in declining corporate bond spreads. It is evident in the stabilizing housing market in the US, a drawdown of inventories and rising base metal prices. Even the indicators of the financial crisis like credit spreads for banks or money market rates are improving. 

So what is the outlook for the next quarters? If, for a moment, we take former recessions as a point of reference, then as a rule of thumb, about 50% of production losses during the recession can be made up for within two quarters of a recovery. And usually in a recovery phase it takes roughly the time span of the preceding recession to offset the production losses in full. Applying this rule of thumb leads to favorable growth rates for the upcoming quarters. But of course this recession is different. It is characterized by the financial crisis, which, according to conventional wisdom, will curtail the momentum of the recovery. Credit will not be flowing abundantly to corporates and private households, as banks are still shoring up their capital and reducing risks. Taking this into account, we expect a significantly longer recovery phase until the production losses have been recouped. But even then we would expect production in the OECD area to grow by an annualized 3% in the second half of 2009 versus the first half. How about inflation? Given weak pricing power of the corporate sector, it seems pretty clear that price Inflation will remain rather low for the remainder of this year, at least assuming commodity prices stabilize on their present levels. Experience tells us that it usually takes a couple of quarters until price inflation reacts to a post-recession demand recovery. This leads us to forecast a gradual increase of headline inflation in the course of 2010, going up to around 2% in the EU and the euro region and about the 3% in the US.

Of course there are risks. As in any rebound situation, a big concern is the lagged rise in insolvencies and unemployment. Looking at former recessions, insolvencies and unemployment kept rising for about half a year or even a full year after demand had reached bottom and started recovering. Higher insolvencies and higher unemployment do not prevent an economic recovery from happening, but they do make it vulnerable with respect to possible exogenous shocks. Such shocks are hard if not impossible to forecast, but some candidates that come to mind are renewed shock waves in the financial sector causing doubts about the stability of the banking system, adverse developments in commodity prices,  widespread protectionist tendencies or natural catastrophes. Such disturbances could always put an early end to the recovery.

This creates a challenging environment for economic policies. On the one hand it is necessary to nurture the seeds of the recovery by expansionary policies, on the other it is important to take steps towards more balanced budgets. Consolidation of public finances is obviously of essential importance for future generations but, if done too early in the cycle, it may cut off the green shoots that have just appeared on the surface. But actually this risk of premature policy contraction does not seem very acute, as the expansionary measures will be effective throughout 2010 and there are still discussions about yet further stimulus packages, not least in the US and in Germany.


 Dr. Michael Heise

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