2010 Economic Outlook
Richard B. Hoey
November 3, 2009
Evidence continues to accumulate supporting our thesis
that the U.S. and global recessions are over and that
sustained economic recoveries have begun, both in the
U.S. and worldwide. The “global emergency rescue” of the
financial system and the economy was a major success, at
least from a short-term cyclical perspective and probably
from a long-term perspective as well. Aggressive global
policy stimulus in the form of central bank liquidity
actions, monetary stimulus and government fiscal
stimulus occurred in many different countries and
succeeded in calming the financial crisis, ending the
recession and starting a global expansion.
Macroeconomic policy is stimulative in nearly every
country in the world and we expect this harmonic of
simultaneous macroeconomic stimulus to generate
sustained expansion in nearly every country in the world in
2010.
There are a number of key issues. A summary of our
views on these key issues follows. We expect a sustained
global expansion at about a 4% real GDP growth rate in
the last half of 2009 and the four quarters of 2010, with
financially strong countries leading and “debt hangover”
countries growing more tentatively. We expect a
sustained U.S. economic expansion at a real GDP growth
rate of 3% to 3.5% in the last half of 2009 and the four
quarters of 2010. The sustained U.S. expansion should be
at a pace somewhat above the long-term trend growth
rate near 2.5%, but well below a normal rebound after
such a severe recession. The economic recovery should
be ”above-trend but below-normal.” We believe that a
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Chief Economist, BNY Mellon
bnymellon.com
double dip recession is quite unlikely. We disagree with
forecasts of a major further rise in the personal savings
rate in the U.S., as income growth may be too sluggish to
support it. We believe that the developed economies face
a “job-light recovery,” with labor markets only slightly
stronger than in a “jobless recovery.” The official U.S.
unemployment rate should peak in the spring of 2010
near 10.5%, followed by only gradual improvement. The
persistence of high unemployment in the developed
economies should create recurring “trade skirmishes” and
concerns about the risk of a “jobs trade war.”
We believe that high current budget deficits are not a
major problem, but that high long-term structural deficits
are a very serious problem about which little serious
policy reform is likely in the next few years. In our view,
stimulative monetary and fiscal policies have largely
worked to reflate real economic activity and securities
prices. However, we believe that they are not likely to
cause a major upsurge in U.S. inflation any time soon. We
do expect a “headline headfake” as the 12-month rate of
consumer price inflation reflects first the fall from $147
crude oil and then the rise from $30 crude oil.
We concede that, at the worst of the financial crisis, there
was some risk of a global depression, although that was
not our forecast. However, we believe that risk has
passed, as we anticipated. We expect a trend of gradual
financial recuperation to persist, despite residual
pressures from collateral deflation in residential real
estate and commercial real estate. Federal Reserve policy
 
remains anti-deflationary in the context of a collateral
deflation. Our most likely case is that the Federal funds
rate will start its cyclical rise in late 2010. We believe that
the 28-year-long Treasury bond bull market is over, to be
followed over the next decade by a “secular neutral” trend
in bond yields. With respect to the dollar’s exchange rate
against currencies of other developed countries, we
believe that the dollar is now in the final quarters of a
major multiyear decline. We believe the decline will have
run its course before the end of 2010 as the markets begin
to anticipate future Fed tightening. We are unsure how
weak the dollar may be in the meantime.
What kind of economic recovery is likely in the world and
U.S. economy? The IMF has revised up its 2010 global
growth forecast to about 3%. We believe that the most
likely outlook is that the global economy has begun a
simultaneous worldwide expansion and that the global
growth rate in 2010 should be closer to 4%. The
synchronization of economic weakness in nearly all
countries during the financial crisis intensified global
economic weakness, but now the synchronization of
policy stimulus and recovery in nearly all countries should
make a positive contribution to the strength of the
recovery.
Evidence in support of our expectation of simultaneous
global expansion has strengthened. Leading indicators
and purchasing managers’ surveys have been rising in
many parts of the world. Risk spreads in the bond markets
have narrowed. Yield curves have steepened. Stock
prices and commodity prices have risen. Consumer and
corporate surveys have improved. Real GDP has begun a
sustained rise in most countries. The global expansion
should be led by emerging and emerged economies with
strong balance sheets as well as by some commodity-
exporting countries, while those countries suffering from a
housing bust and a debt overhang should expand at a
more tentative pace.
What is the outlook for the U.S. economy? In the Postwar
period in the U.S., mild recessions have been followed by
mild recoveries and severe recessions have been followed
by strong recoveries. If one were to go by historic
precedents, the extremely severe U.S. recession, which
has just ended, might be followed by a real GDP growth
rate of 8% or more in the following four quarters. We
doubt that will occur this time. We expect a real GDP
growth rate in the U.S. of about 3% to 3.5% from mid-
2009 to the end of 2010. We believe that the long-term
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2010 ECONOMIC OUTLOOK — November 3, 2009
trend growth rate in the U.S. is about 2.5%. Because
growth is likely to be only slightly above this long-term
trend growth rate, the U.S. recovery should be regarded
as below normal relative to past Postwar rebounds. The
recovery in the U.S. should be “above-trend but below-
normal.”
Unemployment rates are likely to remain high in many
developed countries. After the three most severe Postwar
recessions in the U.S. (1957-1958, 1973-1975, 1981-1982)
reached bottom, real GDP grew at an average growth rate
of about 8% in the first four quarters of the subsequent
expansion. This was about 450 to 500 basis points
above trend. In each of these cases, real consumption
rose more than 6% in the first four quarters of recovery.
The well-above-trend growth rate in these prior cycles
strengthened demand for workers. In contrast, U.S.
economic growth in the current expansion might be only
modestly above trend, due to weak income growth, the
negative wealth effect from lower house prices, the
reduced share of highly cyclical manufacturing
employment in the labor market, and the weakness in
both the supply of credit and the demand for credit.
While the demand for credit to refinance old debt is high,
the demand for credit to finance new spending is
relatively weak. Despite strong improvement in the
availability and terms of credit for corporate borrowers,
availability and terms for small businesses and consumers
are still somewhat strained. The result is likely to be a
weak pace of economic recovery and a long period of high
unemployment. We expect the U.S. unemployment rate
to peak near 10.5% in the spring of 2010 but then to
decline only gradually. Despite the weak dollar, a number
of factors and policies are acting as a drag on U.S.
competitiveness, which should tend to mute the pace of
recovery in the labor market.
The initial stage of the coming U.S. economic recovery is
easier to understand as an exhaustion of sources of
extreme weakness than as the sum of sources of strength.
A key to understanding current economic realities is that
while the changes in key variables (real GDP, production,
operating rates, income) are shifting from negative to
positive, the levels of many economic variables will
remain deeply depressed relative to normal. The good
news is about the direction of change, but the bad news is
about levels.
Auto sales have been so severely depressed for so long
that there has finally been some buildup of pent-up
 
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demand. Another sector where the downtrend is showing
signs of exhaustion is U.S. residential construction, which
we believe has begun a sustained recovery. Although we
expect an “L-shaped” pattern in house prices, we believe
they have begun the bottoming process. As severe
liquidation of inventories gives way first to a slower pace
of liquidation and eventually to modest positive
accumulation, the contribution to real GDP growth should
swing from negative to positive. This process began in the
third quarter, but should persist over the next year. The
outlook for capital equipment spending is also improving.
The private structures component of capital spending
should remain weak, given the serious problems in
commercial real estate. State and local spending is likely
to stay sluggish for an extended period of time.
Some analysts argue that the savings rate will continue to
shift dramatically higher. We think that further increases
may be more muted than is currently expected by many
economic pessimists. We believe that (1) consumers will
desire to raise their savings rate, (2) it is advisable that
they succeed in doing so and (3) there are likely to be
adverse long-term consequences if they don’t.
Nonetheless, we don’t expect that much more of an
increase. Income growth may prove so sluggish that they
prove unable to achieve their savings objectives. Interest
rates are low and many dividends have been cut or
eliminated, creating an income challenge for many,
especially those who are retired. In addition, wage
inflation is on a decelerating trend, creating another
challenge for income growth.
Commercial real estate is under stress. There are serious
difficulties in refinancing commercial real estate. One
result of the financial crisis and Great Recession was to
lower demand for commercial space and drive up
vacancies, thus weakening commercial rents. As
bankruptcies of tenants continue and leases roll over at
lower rents, cash flows are likely to drop.
What is most needed to limit the magnitude of “collateral
deflation” in commercial real estate is the “macro fix” of a
sustained economic expansion. Even though we believe
that this will occur, the financial losses in commercial real
estate are expected to be severe given the likely severity
of the decline in cash flows. Unlike residential real estate,
however, commercial real estate is not the core of
consumer net worth, limiting the spillover impact on
consumption.
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2010 ECONOMIC OUTLOOK — November 3, 2009
A key issue for the outlook for 2010 is the transmission of
monetary ease into the U.S. economy. In 2009, the
securities markets were major channels for transmitting
monetary ease into the economy. There was a sharp drop
in the cost to corporations of new equity capital and debt
capital, as a result of the stock market rally and the
narrowing of credit risk spreads on both investment grade
bonds and high yield bonds. Corporate balance sheets
were strengthened initially through equity financing and
“long funding” of short-term debt. Now that profits are
rising, many major companies are in a financially strong
position and able to adopt a longer term perspective on
business opportunities and risks. As a result, we believe
that capital spending is at an inflection point from a
decline to a sustainable expansion.
However, that is not the complete story, as the terms and
availability of credit for consumers and small businesses
has not improved to the same degree. The availability of
auto credit has improved due to substantial government
support, but other consumer debt is not as easy to obtain.
The small and mid-sized banks are more stressed than
the large banks by weakness in commercial real estate
and some small and mid-sized companies themselves are
owners of commercial real estate for their own use. Some
specialized lenders to these markets are under stress.
We expect a slow recuperation of credit availability to
these sectors over the course of 2010, a critical factor in
our forecast of a moderately favorable economy in 2010.
The U.S. faces huge budget deficits today (a minor
problem) and huge budget deficits forecast for years to
come (a major problem). While the current budget
deficits are cyclically appropriate, the persistent budget
deficits are inappropriate. Some fear a future spike in
inflation, some fear a future spike in real interest rates
(interest rates minus inflation) and some fear a foreign
exchange crisis. Our view is that the high budget deficits
of today do not preclude a substantial economic recovery
at an above-trend but below-normal pace. We are not
optimistic about any early shift to a more disciplined fiscal
policy. However, we believe that the U.S. has
“demographic flexibility” which could mitigate the aging
of its population to the degree it chooses to modify its
immigration policy over the coming decades.
Another controversial issue is climate change. Climate
change negotiation can either raise or lower the risks of a
“jobs trade war,” depending upon whether the outcome is
 
3
conflict or cooperation. The relative competitiveness
among countries is influenced by the level and expected
trend of relative labor and non-labor costs, relative taxes,
exchange rates and relative carbon costs. Carbon tariffs
have already been proposed in the U.S. and Europe to
offset potential carbon cost advantages of foreign
suppliers. Carbon tariffs should gain growing attention as
the debate intensifies about the impact of climate change
issues on relative competitiveness and relative
employment growth. A persistently high unemployment
rate in developed countries is likely to increase
protectionist sentiment and raise the risk of a “jobs trade
war.” We believe that the key to limiting the risk of a “jobs
trade war” is for the global economic expansion to be
sustained at a good pace, maintaining hopes for a future
fall in the unemployment rate.
Views about future inflation in response to recent
monetary policy and expected future monetary policy are
at the core of many current debates about the economic
and market outlook. Six key aspects of the inflation
outlook are (1) the commodity supercycle thesis, (2) the
money growth perspective, (3) the output gap
perspective, (4) the inflation expectations perspective, (5)
the public opinion/political perspective, and (6) the
currency perspective.
There is increased demand for commodities from
emerging market countries, but it is still early in the global
economic expansion. Barring a major military incident in
the Middle East, we expect energy prices and other
commodity prices to churn in neutral in the near term, as
the supply/demand balance appears adequate at this
phase of the cycle.
Inflation pessimists expect a major acceleration of
inflation in future years in response to the rapid
acceleration of reserve growth and money supply growth
that has occurred in response to the financial crisis.
However, the large increases in the Fed’s balance sheet,
the monetary base and money supply are not being
mobilized quickly into debt-financed spending given the
combination of a reluctance to borrow and a reluctance to
lend. Procyclical tightening of financial regulation and
orderly deleveraging should contribute to a relatively
sluggish recovery in private credit growth in the early
stages of economic recovery.
Another perspective on inflation is linked to the output
gap, an economic measure of the degree to which actual
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2010 ECONOMIC OUTLOOK — November 3, 2009
output falls short of the potential capacity to produce
goods and services. The severity of the recent global
recession is such that it is clear that the world faces a
major output gap with an excess supply of both
productive capacity and labor. This is intensified by the
continued government support in emerging markets for
further increases in productive capacity and the
continuing shift of low-skilled labor into the modern labor
force in those countries.
Another perspective on inflation is that of inflation
expectations. There are occasions when self-feeding and
unstable expectations of inflation and deflation can
contribute to a vicious cycle of worsening inflation or
deflation, sometimes reinforced by major currency
swings. At other times, long-term inflation expectations
are “anchored” near a certain rate, dampening the
tendency for actual inflation to deviate for long from that
norm. In the aftermath of a deflation shock, Chairman
Ben Bernanke wished to drive inflation expectations back
up. So far, long-term inflation expectations have only
risen back to normal. We expect a normalization of
inflation expectations rather than either a deflationary or
inflationary spiral.
It has been 30 years since Americans have felt the full
pain of excessive inflation. They are currently
experiencing the pain of excessive deflation, especially in
real estate. In this context, many people do not see
fighting inflation as a major priority.
There have been widespread concerns that dollar
weakness could drive up U.S. inflation. In the current
context, we do not believe that a low level for the dollar is
very inflationary, although it made some contribution to
higher oil prices. The supply capacity for consumer goods
imports from emerging economies is quite ample and
there is little chance of significant bottlenecks in the U.S.
economy.
There has been a great deal of discussion about reserve
diversification recently. Foreign countries have always
had the flexibility to shift their currency reserves out of
the dollar to other currencies or to utilize their excess
currency reserves for other investments or for domestic
spending. While the dollar has its issues, so do such
competing currencies as the euro, the pound sterling, the
yen, etc. We believe that the multiyear process of
currency diversification is likely to prove orderly as long
as the Federal Reserve retains credibility with respect to
 
4
its management of domestic inflation risks. For now, we
believe that U.S. policymakers are tolerant of a depressed
level for the dollar in the current cyclical phase of
depressed economic activity and “collateral deflation” in
real estate. The Fed’s true dual mandate is domestic
employment and domestic price stability. The recent
dollar weakness is not a near-term problem for either
mandate. At a different cyclical phase, both the markets
and the policymakers are likely to change their views. We
expect the Federal funds rate to begin to rise by late 2010,
which should trigger a shift in dollar sentiment at that
time. However, over the next several quarters, we are
uncertain whether the dollar will trace out a rounding
bottom or might end its decline with a major overshoot,
although we believe that the less dramatic pattern is more
likely.
Some observers have argued that the recent financial
crisis was unprecedented. We disagree. The recent crisis
was one of a long line of financial crises over the decades.
In the U.S., prior crises in the last four decades include the
Penn Central commercial paper crisis of 1970, the oil price
shock of 1974, the Hunt silver crisis of 1980, the
Continental Illinois bankruptcy of 1984, the stock market
crash of 1987, the savings and loan and junk bond crisis of
1990, the Mexican financial crisis of 1995, the combined
Asian crisis, Russian default and Long-Term Capital
Management crisis of 1998, the technology bust and the
WorldCom/Enron bankruptcies at the beginning of the
century.
The global history of repeated crises has been
documented in such books as “Extraordinary Popular
Delusions and the Madness of Crowds” by Charles
MacKay, “Devil Take the Hindmost: A History of Financial
Speculation” by Edward Chancellor, “Manias, Panics, and
Crashes” by Charles Kindleberger and others and “This
Time is Different: Eight Centuries of Financial Folly” by
Carmen Reinhart and Kenneth Rogoff. The other lesson of
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2010 ECONOMIC OUTLOOK — November 3, 2009
history is that policy is powerful. It can create bubbles. It
can create busts. It can also create expansions after
severe financial crises. There will be a price to pay over
the coming decade for all global macroeconomic stimulus
now pulling the world out of recession, but the price will
be less than would have been paid in the depression
which could have occurred in its absence.
The U.S. has benefited from declining interest rates for
nearly three decades. We outlined the logic for a
persistent decline in long-term yields in our May 25, 1981
Forbes column, entitled “Last Chance This Century.” Our
view is that a 28-year secular decline of about 1400 basis
points in yields on 10-year Treasury bonds has now
ended. We believe that the decline from 16% on
September 30, 1981 to near 2% at the end of 2008 has
completed the secular decline in Treasury yields. The
secular bull market in Treasury bonds lasted more than a
quarter century, but we believe that it is now over. Some
will label the next decade or two a secular bear market in
Treasury bonds, since Treasury yields are unlikely to drop
below their December 2008 lows. However, we believe
the most likely bond market outlook is better described as
a “secular neutral” trend in interest rates. Over the next
decade, we would expect a “secular neutral” center of
gravity for 10-year Treasury yields of around 4% to 4.5%
with a normal range of about 100 basis points on either
side of this center of gravity (and an extreme range of
about 200 basis points on either side). We believe that
the cyclical rise in long-term rates has begun but believe
that it is premature to expect substantial further increases
soon, even with the large Treasury calendar. The appetite
for accumulating Treasury securities on the balance sheet
of financial firms and intervening central banks abroad is
not likely to ebb quickly if we are correct that the first Fed
tightening is likely to be delayed by concern about the
risks of collateral deflation.
 
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