London's Tower Bridge - - Credit: Vic Thomasson/City of London

Morgan Stanley, the US investment bank, said last week in a commentary on the global economy, that it expects a prolonged period of relative economic stagnation in the G7 countries (Canada, France, Germany, Italy, Japan, UK and the US ) rather than a deep recession, and it believes that persistent underlying inflation pressures will limit the oil price-induced decline in headline inflation rates that lies ahead. The investment bank says that stagflation is still the name of the game, in its view, limiting the major central banks’ room for manoeuvre on interest rates in both directions.

Joachim Fels, who is a Managing Director and Morgan Stanley's Chief Global Fixed Income Economist and Strategist, based in London, said that the "two key global macroeconomic issues investors want to discuss with us these days are 1) how long and how deep the economic downturn will be, and 2) whether inflation is still a threat in the medium-to-long term despite slower growth and lower commodity prices."

Fels wrote: "Given the amount of pushback we are getting from those who think that recession and sharp disinflation (or even deflation) will rule, it is worth laying out the arguments for ‘stag’ and ‘flation’ again, incorporating recent developments."

Why not a sharp recession in the G-7? Morgan Stanley said that the typical ingredients for a deep contraction in total economic activity (as opposed to a broad stagnation or a mild technical recession) are not in place.

No excessive monetary tightening: MS says deep recessions are usually preceded and caused by a very significant tightening of monetary policy that pushes real interest rates way above their neutral levels.  By contrast, the monetary tightening that preceded the current downturn was very modest indeed – most major central banks only returned rates to a roughly neutral range in the 2004-07 rate hike cycle.  Also, the global liquidity (or savings) glut emanating from emerging markets kept long-term rates relatively low.  Moreover, the Fed cut interest rates earlier and much more aggressively than ahead of past recessions.  This helped to contain the tightening of overall monetary conditions due to the credit crisis.

No massive overinvestment in the corporate sector: Deep recessions usually involve very sharp contractions in capital spending by the corporate sector, because they tend to be preceded by massive overinvestment in the boom. However, companies didn’t overinvest (on a macro scale) in the last upswing, mainly because they still remembered the capex (capital spending) boom and bust of the late 1990s and early 2000s.

Oil prices have retreated: Deep recessions are often preceded by a sharp rise in oil prices, so the run-up in oil prices from US$50 per barrel last year to US$150 earlier this year would seem to support the recession call. However, oil producers have been quick to spend their additional revenues domestically or recycle them into global financial markets, thus cushioning the shock.  Moreover, oil prices have now retreated by some 25% from their peak, providing some relief for battered consumers.

EM slowing but still cushioning: While overall economic growth in most of the EM is slowing, this is largely due to exports rather than domestic demand.  Relatively solid domestic demand growth in EM, reflecting a still expansionary monetary policy stance and progressive fiscal easing, should continue to support G7 exports and thus cushion the downturn.   

Look for a long period of relative stagnation instead: MS says that even though it doesn’t foresee a sharp recession, its G7 economic outlook is far from rosy.  Over the next several quarters, it sees virtually no growth overall, with a technical recession still likely in the US during the winter, and Europe (including the UK) and Japan bumping along the zero line.  Moreover, while moderate recoveries look likely at some stage during 2009, MS expects them to be very hesitant and sub-par, for several reasons:

Little room for monetary easing: Given the low starting point for rates in most countries and given the expectation that underlying inflation pressures to remain elevated, there is very little room for the major central banks to ease monetary policy aggressively. MS says - no major easing, no vigorous economic recovery.

Tight credit for longer: MS says credit conditions will undoubtedly remain tight in the foreseeable future as banks continue the deleveraging process.  As it discussed a few weeks ago, major credit crunches in the OECD countries from 1960 onwards have lasted about 2.5 years, while we are now only about a year into this credit crunch (see “Of Disasters, Recessions, Crunches and Busts”, The Global Monetary Analyst, August 13, 2008).

Busting house prices: MS says the house price busts in the US, the UK and several other European countries are far from over. Severe house price busts in the OECD since 1960 have on average lasted 4.5 years and have seen house prices correcting by a median 28.5% (see article quoted above).  MS says that although the negative wealth effects of falling house prices tend to be overestimated, lower house prices will weigh on construction activity and imply that households have less collateral to borrow against for spending.  Thus, MS looks for a gradual rise in savings rates, especially in those countries ( US, UK) where savings rates were run down progressively during the last boom. 

Reduced growth potential: MS says last but not least, the medium-to-long-term growth outlook is overshadowed by what it thinks is a downshift in potential output growth in many industrialised economies.  As it  discussed a month ago, the past energy price shock and the credit crisis combined could shave about half a percentage point or more off potential GDP growth in the US and the euro area in the next several years (see “Potential Growth Is Slowing, Too”, The Global Monetary Analyst, July 30, 2008). In addition, while even more difficult to quantify, the trend towards re-regulation and protectionism will likely dampen underlying growth, too.  Thus, the important takeaway here is that the current downturn combines elements of a demand-induced cyclical (temporary) slowdown and a supply-side induced structural (lasting) downshift in potential output growth. 

Why inflation will remain an issue: MS says sentiment on the other big macro issue apart from growth – inflation – has swung massively over the past couple of months.  While inflation fears were raging high until July, market-based measures of inflation have dropped dramatically since then, with US breakeven inflation rates now at their lowest levels since 2003. Back then, central banks and markets fretted about deflation!  The MS view is that despite the coming decline in headline inflation due to base effects and lower oil prices, underlying inflation pressures will remain elevated and inflation rates will hover in a higher range over the next several years than we got used to in the last 15 years or so. Here’s why:

Lax global monetary policy: MS says that the global monetary policy stance as measured by real short-term interest rates is the easiest it has been for more than a decade.  Ultimately, monetary policy determines the longer-term inflation trend.  True, monetary conditions in the industrialised countries are tighter than the level of real short rates alone suggests due to the endogenous tightening in the financial system.  Yet, in many emerging market countries, low or negative real rates and strong credit expansion point to easy monetary conditions, which are likely to spill over into industrialised countries via higher import prices.

Less slack than meets the eye: As explained above, while demand is slowing, potential GDP growth is downshifting, too.  Thus, this downturn will create less economic slack than generally presumed, and thus less cyclical downward pressure on inflation.

Watch wages: In many countries according to MS, the pendulum is swinging back towards more redistribution and giving a larger share of the economic pie to workers.  Following many years of wage restraint in the euro area, for example, wage growth has only started to pick up.  With wages following the labour market with long lags there, and unemployment having fallen until recently, wage pressures are likely to rise rather than fall in the foreseeable future. 

Bottom line: Rather than a deep recession, Morgan Stanley continues to expect a prolonged period of relative economic stagnation in the industrialised world – or as in the US, mild technical recessions. No deep recession, no vigorous recovery. With potential growth downshifting, too, and global monetary policy very easy, underlying inflation pressures should remain elevated, despite the coming decline in headline inflation. The uncomfortable mix of no growth but lingering inflation pressures severely limits central banks’ room for manoeuvre on interest rates.  Specifically, MS continues to think that market expectations of major rate cuts in the euro area and in the UK will be disappointed.