The two top economists at US investment bank Morgan Stanley, said on Tuesday that the recent fragile recovery is not a reason to extrapolate slower growth.  On the day when the Federal Reserve downgraded its outlook for the economy, Richard Berner and David Greenlaw said there's no mistaking the slowing in incoming US economic indicators, ranging from past consumer spending and income to employment and forward-looking orders.  But extrapolating the recent deceleration in the economy into still-slower growth would be a mistake, in their view.  Instead, they see a moderate pickup ahead, with the Q2 downshift marking the transition to a period of unspectacular 3-3.5% growth.

Also on Tuesday, The Wall Street Journal released partial results of its monthly survey of economists, which showed that by a two-to-one margin Wall Street economists see deflation as a bigger threat to the US economy over the next three years than inflation.

“Deflation is dangerously close,” said David Resler of Nomura Securities, one of 53 economists surveyed by the Wall Street Journal. Among economists who answered the question, nearly two-thirds said that deflation poses the bigger risk to the economy over the next three years; the remainder said inflation is the bigger threat. That compares to an April survey, when the economists were split 50/50 over whether inflation or disinflation posed the bigger risk over the next year.

The Morgan Stanley economists said that they are lowering their forecast trajectory for inflation, which means a later exit for the Fed and a lower trajectory for long-term yields. They still think inflation has bottomed, but the acceleration next year will likely be slower - - to 1.75% for core (excluding food and energy) CPI versus 2% previously.

Two point four: barely sustainable.  The economists say the deceleration in GDP (gross domestic product) growth from 5% in Q4 2009 to 2.4% in Q 2 2010,  has reinforced the consensus outlook for sluggish, below-trend growth.  Extrapolating that deceleration, many believe that 1-2% growth in H2 2010 is a given. 

Berner and Greenlaw agree that 2.4% growth lies barely on the threshold of a sustainable economic recovery:  It is just fast enough to generate the jobs and hours needed to extend income growth for moderate gains in consumer spending.  But it is not fast enough to continue to narrow slack in the economy - - key for reducing the tail risk of deflation and maintaining operating leverage for corporate profits.  So a pickup in both demand and output are critical to assure self-sustaining growth.

Mohamed El-Erian, CEO and and co-CIO of trillion dollar bond fund manager Pimco, discusses the Fed's "new normal" with CNBC:

Four factors driving a pickup.  The economists say that the current deceleration in economic activity is largely a reaction to the spring shock from the European sovereign credit crisis.  That shock had a bigger impact on US growth than they expected earlier this year, because it triggered a sudden, temporary tightening in financial conditions and increased uncertainty about the sustainability of global growth.  

But four factors are likely to promote improvement: 1) Financial conditions have eased again, 2) global growth will contribute to US growth, 3) domestic demand and income gains are gradually firming, helped by accelerating infrastructure outlays, and 4) the inventory cycle is not over. 

1. Financial conditions have eased, with the capital markets opening again and risk appetite returning.  High yield and investment grade corporate spreads widened significantly this spring, but rates have since declined in absolute terms to record lows.  Conventional, 30-year mortgage rates have plunged by 0.7%.  The dollar on a broad-trade-weighted basis has reversed its spring rally.  And stock prices have reversed about half their swoon since April. 

2. Global growth is still hearty.  Berner and Greenlaw say it appears that the Chinese economy has slowed in response to restraints on lending and tighter monetary policy.  But they estimate that it is slowing from 10% this year to 9.5% in 2011 - - still strong.  So while net exports sliced 2.8pp from Q2 growth in the US, they believe they are poised to improve dramatically.  The sharp widening in the US trade gap in Q2 did not reflect weak exports; they rose at a 10.3% annual rate, even though weak agricultural exports trimmed the gain.  The drought in Russia and bumper US inventories will probably combine to boost farm exports in H2.  More important, the 35% annualized merchandise import surge in Q2 was a temporary anomaly.  The jump in oil imports seems to reflect one-time offloading of crude cargoes from ships on the water to tank farms, and the surge in consumer and automotive imports probably will unwind quickly, as it far outpaced the swing in inventories and final sales. 

3. Modest but sustainable gains in domestic demand.  Domestic final demand accelerated to a 4.1% clip in Q2.  A significant slowing is underway; indeed but that lower pace should be more than sustainable.  Among the reasons:

• Despite tepid July employment data, gains in the workweek and wages still seem likely to yield annualized gains in real disposable income of 3%-plus in H2; that is more than sufficient to sustain both 2-2.5% consumer spending growth and a further rise in the personal saving rate.  The economists say sharp (2pp) upward revisions to the personal saving rate over the past two years to 6.2% hint that consumers have rebuilt saving and balance sheets by paying and writing down debt - - deleveraging - - by more than previously thought.  Consequently, the headwind to consumer spending from deleveraging is a smaller risk to the outlook as consumers can spend more of their income in H2. 
• The extension of unemployment insurance benefits and aid to state and local governments, restoring $60bn in temporarily-suspended fiscal stimulus, should add to incomes and confidence.  That would especially be the case if state and local governments use the funds to rehire the 48,000 workers furloughed in July as the fiscal year began.  Moreover, Berner and Greenlaw expect that Congress will agree to extend many, if not all, of the tax provisions that expire on December 31st  for one year.  While that could generate uncertainty about tax policy, it should avoid near-term fiscal drag. 
• Profit margins have yet to peak, providing wherewithal for capital spending, and companies have begun to invest to replace worn-out and obsolete equipment in a sustainable way. 
• Finally, infrastructure spending, the last part of the fiscal stimulus enacted in 2009, is now gathering steam.  Double-digit spending gains for infrastructure should offset any further weakness in local government hiring.

4. The inventory cycle is not over.  While outsized contributions to output from inventory accumulation are unlikely, inventories have become exceptionally lean in relation to sales.  Notwithstanding the secular decline in inventory-sales ratios resulting from just-in-time inventory management techniques, if we're close to right that overall final sales (including net exports) run at a 3% rate, inventories will fall too low in some industries unless production steps up in tandem.  As further evidence, the ISM (Institute of Supply Management)manufacturing customer inventory index at 40 is well below historical norms. 

There continue to be two key risks to the MS moderately upbeat scenario:

1.         Housing.  In addition to the ‘payback' following expiration of the first-time homebuyer tax credit, the downside risks to home prices, mortgage credit availability and housing demand are still present. 

2.         Policy/political uncertainty.  The economists think that increased uncertainty around taxes and implementation of healthcare and regulatory reform is one reason why consumer confidence slipped in the last couple of months. 

The case for a gradual rise in inflation.  Firming rents and narrowing slack reinforce the conviction that inflation is bottoming and that the deflation scare is just that - - a scare.  Evidence for rising rents began accumulating late in 2009, as apartment vacancies fell.  From January through May, rents climbed 2.8% nationwide, according to Axiometrics, which tracks the national apartment market.  Those increases move through the popular price gauges like the CPI on a six-month moving average basis, so the increases seen in May and June likely will persist. 

Thanks to hearty gains in output and cutbacks in capacity, moreover, operating rates have jumped 580bp (5.8%) from their trough; that's long been a key factor behind the above-consensus inflation call.  The idea that ‘speed effects' - - or changes in slack - - as well as its level have an impact on inflation is controversial and difficult to pin down empirically, although it makes intuitive sense. The economists say the notion is that a trough in operating rates or a peak in the jobless rate will trigger a change in direction in businesses' and consumers' outlook for the factors that drive inflation. It may be reinforced by the fact that cyclically sensitive prices, like those for food and energy or other commodities, will rise in recovery.  Consequently, speed effects are strongest for wholesale or producer prices, but they believe that they matter for consumer prices as well.

Looking ahead, the coming rise in inflation will likely be slower than the economists had been expecting, courtesy of smaller declines in capacity and thus smaller speed effects.  The strong gains in capital spending seen since the start of the year are offsetting ongoing cuts to industrial capacity, which declined 1.6% since late 2008; capacity just began to level off in Q2.  As a result, they now see core inflation ( excluding food and energy) measured by the Fed's preferred gauge (the PCE price index) at 1.8% in 2011, about 0.4% higher than its pace over the past year but a quarter-point below the MS earlier forecast.