The few historical parallels where recessions are triggered by excess debt and financial crises can be misleading, as these have tended to be localized, regional affairs which were often resolved in part through currency devaluation, making fiscal consolidation less painful. In the current scenario, both public and private debt levels are extremely high and the problems are common to almost every developed nation. The great irony is that most of the important emerging market economies have the best fiscal dynamics, the freest markets and strongest growth prospects, reversing position with the so-called ādevelopedā economies. Competitive devaluation in a globally fragile situation is not an available solution to everyone. Perhaps the lone benefit of such a coordinated crisis is that itās hard to tell whose sovereign debt smells worse. However, with so many G20 countries with unsustainable fiscal positions, the risk of contagion is high.
The bottom line is that this is an untested economic environment with a highly uncertain outcome. Monetization of vast amounts of debt is well underway and set to continue as policymakers desperately try to reflate sick economies. However, as Japan can testify, central bank reflation and zero interest rates donāt necessarily create a sustainable recovery. Despite the concerted effort of central banks to reflate their economies, deflation remains a greater risk than inflation for the foreseeable future. The key determinant of investment returns over the next ten years will probably be dependent on getting the inflation/deflation forecast right (i.e. when the deflation risk shifts to an inflation risk). We do not see that happening any time soon.
Money, Credit and Liquidity
Money supply and credit expansion are generally positive for risk assets but only if price inflation remains stable. The U.S. Federal Reserve (along with most other developed nations) expanded its balance sheet dramatically in 2008-2009. However, money supply growth remained subdued in 2009 as banks have been working through write-downs and have sharply increased their reserve holdings. The private sector has been deleveraging, but this may be changing (see Charts 4-6). If the Fedās aggressive policy does result in a significant expansion of money and credit, it will, at some point, have to start taking action or risk a spike in inflation expectations.
The key question is: When should we expect this to occur? The lag between recovery and price pressure is much longer in the aftermath of a financial crisis than it is after a typical recession. This is because banks remain conservative for a very long time and consumers and businesses focus on balance sheet strength. Indeed, the level of commercial and industrial loans has been declining steadily since mid-2008, although the rate of decline has slowed sharply (Chart 7). Housing markets, consumer demand and employment data are still negative, ensuring that inflationary pressures will be long delayed.
The implications of this view are:
1. Extraordinarily loose monetary policy and near-zero interest rates will persist for at least another 6-12 months.
2. General price inflation in the U.S. and other developed nations will continue to be tame.
3. Asset inflation in emerging markets will continue to put pressure on their domestic monetary policies to tighten and allow their currencies to rise, particularly the RMB.
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