US Economy Now in "Expansion" Mode, is Inflation on the Horizon? Not Necessarily

Morgan Stanley Smith Barney recently reported that the business-cycle recovery of the global economy that began in the summer of 2009 is now over. According to Morgan Stanley, the world economy is in an expansion.

The International Monetary Fund reports that the global economy is now $62 trillion, larger than it has ever been before. It has expanded in real or inflation-adjusted, terms as well. At nearly $15 trillion, the US economy (approximately one-quarter of the world economy) is also larger in nominal terms than it was at the outset of the 2008-2009 Great Recession. Predictions are that in a few months, the US economy is likely to enter into expansion in real terms as well.

The Obama Administration extended the Bush-era tax cuts for nearly two years and reinstated the estate tax at 35% with a $5 million exemption. While the new law does not address the troublesome long-term fiscal deficit, stronger GDP is an encouraging start. Experts are optimistic that some of the recommendations from the Bipartisan Deficit Reduction Commission will be included in the budget that President Obama will send to Congress in February 2011 and ultimately become law. Historically, lower deficits as a share of GDP have been associated with higher equity market P/E multiples (stock market increases).

Recent developments in US fiscal policy have picked up some of the burden of stimulating the economy that the Federal Reserve had been bearing alone. The Federal Reserve bank remains unambiguously committed to engineering a sustainable recovery. In a departure from past policy goals, the Fed is aiming to push inflation higher. Policymakers believe the slack in labor markets and other economic factors may exert downward pressure on the US inflationary trends. By contrast, the Economic Cycle Research Institute’s future inflation gauge suggests that the deflationary pressures bottomed some time ago. Morgan Stanley is not implying that the US is headed toward a bad inflation problem, however it is possible that the Fed may have overestimated creating more than the amount of stimulus necessary, setting the stage for higher-than-desirable inflation and we can expect the Fed tightening sooner than markets anticipate.

Morgan Stanley Smith Barney, Investor Insights “Welcome To the Expansion” January 2011.

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