Our economic outlook is basically unchanged. We believe that a full-scale global recession is unlikely, assuming that there is no major oil price spike from a disruption of the flow of Middle East oil. We believe that a key cause of sustainable global economic expansion will be the easy monetary policy prevailing in many different regions and countries worldwide. We expect a global growth recession in 2012, with declining economic activity in Southern Europe, an economic stall or temporary declines in the U.K. and much of Northern Europe, a moderate slowdown in emerging markets and a U.S. expansion at a near-trend pace in 2012, somewhat faster than last year.

A major disruption in the flow of Middle East oil, unless fully offset by releases from strategic oil reserves, could have the potential to generate a substantial enough rise in oil prices to trigger a global recession. Our outlook assumes that there will not be such a major sustained spike in the price of oil.

In order to sustain economic growth despite persistent debt deleveraging, many of the central banks in developed countries are maintaining very low interest rates. This is mitigating the drag of private sector deleveraging in many countries. Among the developed countries, growth tends to be weak in countries undergoing major fiscal tightening and less weak in countries which have tended to postpone substantial fiscal consolidation.

The economic growth rates in many developing countries have decelerated somewhat this year. We believe that this reflects the lagged impact of (1) monetary policy tightening last year designed to fight inflation and (2) the European financial crisis and recession, which has slowed demand from Europe. Energy-importing countries also face some drag from higher energy prices. Unlike many of the developed countries, very few of the developing countries have interest rates near zero. They have had the flexibility to lower interest rates and many have used that flexibility in recent months. Over the coming year, we expect growing confidence that economic expansion is sustainable in most emerging countries. Despite the peak in the Chinese property market, we do not expect a hard landing in China.

Over the last half-year, fears of a financial crisis in the European financial system have calmed somewhat. Last year, during a worsening financial crisis, European policymakers from disparate countries within the euro had great difficulty reaching agreement on controversial policy decisions. There were fears in the markets that they might act too late to prevent a financial meltdown in the European financial system. However, a major shift in policy at the European Central Bank finally broke the fever in the markets. The ECB's LTRO program flooded the banking system with roughly one trillion euros of three-year liquidity. As a result, the channels of market funding for many European banks have been reopened and yields on the sovereign bonds of many vulnerable countries have dropped. This reduced the "tail risk" of a potential collapse of the European financial system, but did not solve the underlying problems in the Eurozone. Our view is that European financial stresses have shifted from the acute stage to the chronic stage. We expect alternating waves of concern and relief with respect to financial risk in Europe, but do not expect a return to a European financial crisis anywhere near as severe as occurred last year.

The Greek restructuring generated losses of nearly 80% to private owners of Greek bonds. However, this did not trigger a major bout of financial contagion elsewhere in Europe since the ECB's actions had already calmed the liquidity stresses to a substantial degree. We interpret the fact that the new Greek bonds trade at very high yields as a signal of widespread market skepticism about whether the debt relief achieved for Greece will prove adequate in the long run. However, following the selective Greek default, the majority of remaining Greek debt is now owed to the public sector rather than to private investors.

We are hopeful that the key large vulnerable countries, Spain and Italy, will continue to be able to fund in the public markets so that they will not need to rely on firewalls. We believe that this is critical, since the large size of their economies and their debts, combined with the precedent of the severe losses experienced by private sector lenders in the Greek restructuring, may make it challenging for European authorities to build a financial firewall which is completely credible for large countries. We do expect European and international authorities to establish large financial firewalls. If structural reforms proceed and market access can be retained by the large vulnerable countries, the effectiveness of such financial firewalls will not need to be tested. Our most likely case for Europe is a gradual and choppy transition to somewhat more credible economic policies, accompanied by many years of sluggish economic activity in many European countries.

While fears of European financial stresses have dropped, the underlying fundamental problems persist. Disparate countries are bound together to a single currency and a single monetary policy without a fiscal union. We believe that the single monetary policy and the level of the euro have been too stimulative for economic conditions in Germany and have been too restrictive for economic conditions in peripheral countries. Most peripheral and soft core countries in Europe face challenging demographics, substantial sovereign debt and a competitiveness gap relative to Northern Europe, especially Germany. Closing the competitiveness gap is likely to prove very challenging. Relative competitiveness within Europe could be restored by high inflation in Germany and/or substantial wage deflation in Southern Europe. These are not appealing alternatives, subject to "austerity fatigue" in the vulnerable countries and "support fatigue" in the stronger countries. We do not believe that the competitiveness gap is likely to close quickly. The result is likely to be a slow average economic growth rate in Europe in the coming years, with the exception of some of the exporting countries of Northern Europe.

We expect U.S. real GDP to grow at a near-trend pace close to 2.5% in both 2012 and 2013, with the private domestic sector growing at a somewhat faster pace. Given the aggressively stimulative stance of monetary policy, the economy has the potential to grow more rapidly than that, but we believe that it faces an "uncertainty drag," reflecting persistent regulatory and tax uncertainty.

A warm winter has generated complex crosscurrents in U.S. economic statistics, but we believe that the underlying pattern is that the labor market and credit growth have strengthened and key cyclical sectors are in sustainable uptrends. Earlier in the recovery from the recession, a substantial portion of the increase in the demand for labor in the U.S. was met by an increase in the workweek of existing employees, rather than by hiring new workers. Now that the workweek has recovered to more normal levels, a greater portion of the increased demand for labor is being met by hiring new workers. This reality is reinforcing other forces generating a moderate strengthening of the U.S. labor market.

The combination of some wage inflation plus some growth in employment is contributing to a persistent rise in nominal wage income in the U.S. However, real wage income has proved highly sensitive to inflation and thus to energy prices. Low levels of spending on energy due to warm weather this winter proved temporarily favorable for consumer spending on non-energy goods. The current rise in gasoline prices should restrain real income growth for several months, although this is occurring in the context of an improved labor market.

We believe that the U.S. economic expansion is likely to be sustained at a near-trend growth rate, supported by a rising underlying trend in three key cyclical sectors (1) autos, (2) residential construction and (3) capital spending. Demand for autos is supported by an aged auto fleet, widely-available auto credit and a strengthened labor market. In the housing sector, we believe that the volume of residential construction has begun a sustainable uptrend, even though housing prices are still languishing near the bottom of an L-shaped pattern. The cyclical recovery in capital spending continues to be supported by strong corporate cash flow and extremely low interest rates. We also regard it as a positive sign that the growth of U.S. credit has moved into a more normal cyclical expansion than was observed earlier in the expansion. Another favorable factor is the boom in North America in the production of oil and natural gas. This is increasing both jobs and spending. In addition, the prospect of cheaper future energy costs for U.S. manufacturing is bolstering long-term business confidence, in our opinion.

What is going on with Federal Reserve policy? Clearly, Chairman Bernanke has had a cautious view of the strength of the economic recovery, given the burden of excess debt and collateral deflation in real estate. It is striking that he laid out his current policy almost ten years ago, in a speech on November 21, 2002, entitled Deflation: Making Sure "It" Doesn't Happen Here. As he stated in that speech nearly a decade ago: "...a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition. ...So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities." Chairman Bernanke has attempted to lower long-term Treasury yields by direct purchases of Treasury bonds and by verbal easing.

Sentiment about Federal Reserve policy and interest rates has been volatile. Our view has been that U.S. economic growth would be strong enough that the Fed probably would not feel a need to adopt a third round of quantitative easing. However, we believe that it is clear that the Federal Reserve is fully prepared to do so, especially if economic data weakens or the Fed becomes increasingly concerned by the scheduled "fiscal cliff" at year-end 2012.

In a sense, the Federal Reserve has used quantitative easing to engineer a "failure in the Treasury crop," with its purchases of Treasury bonds in the secondary market offsetting a substantial portion of the issuance of Treasury bonds which are needed to finance the deficit. This process of indirectly financing the budget deficits cannot continue forever. Unless new programs of quantitative easing are continually adopted, the private sector rather than the Federal Reserve will eventually be absorbing the supply of Treasury bonds needed to finance the budget deficits.

From a long-term perspective, 10-year Treasury bond yields declined 1430 basis points over a 30-year period from about 16% on September 30, 1981 to about 1.7% in early October, 2011. We believe that this is likely to mark the end of a three-decade-long downtrend in Treasury bond yields. We expect an interest rate normalization over the coming years with a gradual upward drift in yields rather than any sharp upward spike, which might disrupt economic expansion. Slow persistent fiscal policy tightening over the coming years is likely to bias monetary policy to retain an easy stance to help offset the economic impact of the fiscal tightening.

Businesses and consumers face multiple uncertainties. The future of the health care sector of the economy is uncertain, since all or part of the health care act may (or may not) be declared unconstitutional this summer. There are also multiple uncertainties about budget and tax policies. The U.S. faces what Chairman Bernanke has labeled a "massive fiscal cliff" at the end of 2012 of a very large automatic budget tightening embodied in current law. First, the 2% Social Security tax cut expires on December 31, 2012, as does the provision for extended unemployment benefits. Second, all of the Bush tax cuts (not just for the two upper brackets) expire on December 31, 2012. Third, the usual "fix" for the Alternative Minimum Tax for 2012 has not yet been passed. Fourth, there is a large sequester of planned defense and non-defense spending going into effect in early 2013. At roughly the same time, the debt ceiling will need to be raised again.

While we doubt that the "fiscal cliff" will generate a recession, we do expect the concern and uncertainty that it generates to suppress the tendency for a stronger expansion in the U.S. We are confident that the large automatic fiscal tightening at year-end 2012 of about 4% of GDP under current law will be substantially moderated after the Presidential election, avoiding a severe economic shock. However, we are doubtful that these legislative changes will occur in a smooth and orderly process. Economic behavior is likely to be influenced in late 2012 by anticipation of Federal tax and spending changes and in 2013 by the actual decisions made about Federal taxes and spending. Anticipation of higher capital gains and dividend taxes could motivate the distribution of excess financial liquidity to shareholders of public and private companies late this year. At the same time, corporate spending plans for 2013 may be made on a tentative basis in late 2012, with actual spending contingent on resolution of the "fiscal cliff." We believe that the economy is in a sustainable expansion, but the rate of growth is likely to be restrained by the "uncertainty drag."

The statements and opinions expressed in Mr. Hoey's commentary are those of Mr. Hoey as of the date of publication, and do not necessarily represent the views of BNY Mellon or any of its affiliates.

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