IN THIS ISSUE

Economic Outlook

This is Richard Hoey of BNY Mellon with a market commentary on January 27, 2010.

Our outlook continues to be for a sustained global and U.S. economic expansion at an above-trend pace. This is the result of the success of simultaneous macroeconomic stimulation adopted by nearly every country in the world over the last year. The lesson of the last year is that "policy is powerful."

We expect global real GDP growth of 4% in 2010, possibly higher. We also expect sustained U.S. economic expansion at a 3% to 4% pace in 2010, following a similar pace of growth in the last half of 2009. The economic expansion should be subpar relative to a normal recovery from such a severe recession (real GDP recovering at a growth rate of 8% or more) but above trend relative to trend growth near 2.5%.

At the worst of the credit crisis, it was not clear how quickly the main financial channels would reopen. In fact, the improvement in the debt cost of capital and the equity cost of capital has been quite rapid. Now that profits are rising rapidly, the availability of internal and external sources of finance for increased spending has improved substantially. Within the U.S. economy, key cyclical sectors such as autos, housing, capital spending and inventories overshot on the downside during the recession and their recovery should generate economic growth at an above-trend growth rate, albeit one that is subpar relative to past recoveries from severe recessions.

We believe that employment in the U.S. economy is at the bottom and is about to start a gradual increase. Within the labor market statistics, leading indicators such as temporary worker payrolls and the workweek have begun to improve. We expect rising employment to be accompanied by a high unemployment rate in 2010. We expect low inflation in 2010, reflecting decelerating wage inflation and weak rents. The path from consumer price deflation to an accelerated pace of consumer price inflation passes first through the reflation of demand.

There are several recent developments that add to the probability that the deleveraging drag can be absorbed gradually over a period of years. First, stock prices have risen sharply, restoring a portion of lost net worth. Debt becomes more burdensome when asset prices decline, but becomes less burdensome when asset prices rise. While house prices are probably near fair value and are not likely to replicate the rally in stock prices, they could rise in synch with overall inflation over the next decade. Second, current dollar GDP has begun to grow again after its decline during the recession. Positive growth in current dollar GDP cumulated over time can contribute to an easing of debt ratios. The accumulation of increases in current dollar GDP plus some rise in asset prices in the coming years should assist in a gradual improvement in debt ratios and net worth.

How troublesome is the budget deficit? We believe that it depends on the time horizon. In the short run, a high budget deficit is appropriate in the context of weak private sector economic activity. Conditions are cyclically favorable for financing the budget deficit. Inflation is low, the Federal funds rate is zero, the yield curve is steep, major corporations have reliquified their balance sheets and financial intermediaries are willing to expand their holdings of Treasury securities. The domestic demand for Treasury securities should be able to absorb a substantial portion of new Federal debt, although some upward drift in yields may be required to absorb the supply.

The long-term or structural budget deficit outlook is much more worrisome. Demographics and the demand for new government spending programs are putting upward pressure on the path of Federal spending while a somewhat slower pace of trend economic growth should restrain the growth of Federal revenues. Interest rates are likely to rise to more normal levels over time, increasing the debt service cost of the higher levels of Federal debt. For now, however, we believe that the high budget deficits will not interfere with the economic expansion.

We are not significantly concerned about the trend of the dollar against other financial currencies. We expect the U.S. economy in 2010 to be much stronger than Europe, Japan or the U.K. As a result, we expect increased anticipation over the course of 2010 of future increases in U.S. interest rates.

Monetary policy in the U.S. and most other countries remains quite stimulative. With positive inflation and a zero Federal funds rate, short-term real yields are negative. At the same time, the yield curve is very steep. When will the Federal Reserve first raise the Federal funds rate? Our most likely case is in late 2010. Chairman Bernanke is pursuing an anti-deflationary policy, attempting to limit the negative spillover risks from the collateral deflation in real estate. As long as long-term inflation expectations are well behaved and credit growth is weak, the Fed is likely to remain quite stimulative.

We believe that the odds of a double-dip recession are quite low. We would divide monetary policy into five stages: (1) aggressively stimulative, (2) stimulative, (3) neutral, (4) restrictive, and (5) aggressively restrictive. Most countries entered 2010 with either a Stage One policy (aggressively stimulative) or a Stage Two policy (stimulative). Over the next two years, we expect a gradual transition from aggressively stimulative and stimulative policies towards neutral (Stage Three). This is a normal pattern for the early and middle phases of an economic recovery and we do not believe that monetary policy will become restrictive enough to undermine the case for sustained economic expansion.

BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation. The statements and opinions expressed in this article are those of the author as of the date of the article, and do not necessarily represent the views of BNY Mellon, BNY Mellon Asset Management International or any of their respective affiliates. This article does not constitute investment advice, and should not be construed as an offer to sell or a solicitation to buy any security or make an offer where otherwise unlawful.

This material is not intended, and should not be construed, as an offer or solicitation of services or products or an endorsement thereof in any jurisdiction or in any circumstance that is otherwise unlawful or unauthorized. Any investment products or services mentioned here are not insured by the FDIC (or any other state or federal agency), are not guaranteed by any bank and may lose value. Mr. Hoey's comments are provided as a general market overview and should not be considered investment advice or predictive of any future market performance.