On Monday, the International Monetary Fund (IMF) raised its estimate of aggregate financial write-downs to $4,100 billion (U.S. $2.7 trillion, EU $1.2 trillion, and Japan $150 billion), just as the U.S. Treasury secretary was saying banks were well-capitalized.
Now, the IMF has just released growth forecasts that will make even the bears’ heads spin: Their new April 2009 World Economic Outlook report expects global economic activity to contract at negative 1.3 percent in 2009, 1.8 percent lower than the 0.5 percent positive growth they expected in January and 3 percent less than it expected in November at 1.7 percent positive.
By the way, global GDP growth was 3.75 percent in 2008 and 5 percent in 2007.
I would advise investors to carefully take notice of the two freshly released IMF scenarios.
First, their baseline case expects U.S. GDP to bottom out at negative 3.3 percent year-on-year in the third quarter 2009, but lending conditions to cease tightening around the end of 2010 and home prices to fall a further 18 percent from now until the end of 2010. Charge-off rates on U.S. residential real estate loans will peak at roughly 4.7 percent; consumer and commercial real estate loans at 5.3 percent; consumer loans at 5.8 percent; and commercial and industrial loans at 2.2 percent, according to the IMF.
Second, under the IMF adverse (deflationary) scenario, U.S. GDP is expected to bottom out at negative 6.5 percent in 2010; normalization of lending conditions postponed by 18 months; home prices dropping by an additional 35 percent by 2012; and charge-off rates on residential real estate loans peaking at roughly 9 percent; commercial real estate loans at 11 percent; consumer loans at 7.5 percent; and commercial and industrial loans at 3 percent.
Under the baseline IMF scenario, too, the U.S. contraction will push the output gap to levels not seen since the early 1980s.
In relation to the IMF adverse (deflation) scenario, my more abiding concern for the inflation outlook is the collapse in global output gaps and resource utilization (unemployment and manufacturing capacity).
Output gaps and resource utilization climbed to multi-decade highs during the lengthy 2000s expansion. However, the severe economic downturn is fast closing these gaps, with the result that resource utilization returned to its historical average (1990 to present) in the last quarter of 2008.
The linkage between resource utilization and inflation is variable and sometimes operates with a lag. That said, it tends to be the case that core inflation rises when the level of resource utilization is above normal and falls when it is below normal.
In this sense, the long-term average level of resource utilization is assumed to be consistent with stable underlying price inflation and can thus be interpreted as similar to the non-accelerating inflation rate of unemployment. This measure accords reasonably well with historical experience this past decade.
We have seen core inflation in developed markets rising from 2000 through 2002 even as the recession was well under way. Core inflation only began falling when resource utilization slipped below the zero line in 2001. Then, core inflation began to rise again as soon as resource utilization began trending up from 2004 to 2007.
I’m seriously worried about the real possibility of deflation taking hold in some of the developed economies. The downward pressure that will be placed on consumer-price inflation in the coming quarters from the collapse in resource utilization cannot be overstated.
Resource utilization is expected to reach multi-decade lows worldwide. JPMorgan’s GDP projections for resource utilization show a fall to a massive negative four standard deviations below the 1990 to 2007 average by the end of the forecast horizon in the fourth quarter of 2010.
If we extrapolate growth out further and assume only a modest recovery to 1 percent above-trend growth, it would take until 2017 to close the gap! Inflation would be under continuous downward pressure from excess slack during that period.
Bottom line: An extended period of deflation in the developed market economies is not far-fetched based on the extent of the negative output gap and the associated plunge in resource utilization.
Whether or not this happens will depend critically on the timing and strength of the economic recovery and the path of inflation expectations.
Of course, both of these can and will be affected by coordinated monetary policy actions aimed at preventing a deflationary psychology from setting in.
Time will tell, but I would not bet on recovery for now.
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