History Points To US Recovery, But Inflation Will Return - Northern Trust

Tom Burroughes

2 April 2009

Inflation will increase in the US and other countries that have been injecting huge sums of money into recession-hit economies, which makes US bonds unattractive investment in the medium term, the chief economist at Chicago-based bank Northern Trust said.

Inflation could begin to show itself as a significant headache for policymakers by 2011, which would require central banks to tighten monetary policy, Paul Kasriel told journalists at the bank’s offices in London’s Canary Wharf district.

“The Federal Reserve...along with other central banks, is a legal counterfeiter. They can create money out of thin air,” he said.

While inflation is a problem, it is politically more palatable for the US administration of Barack Obama to run the risk of rising rather than falling prices, he said. “The US is a net debtor. Deflation is very difficult if you are a net-debt nation as the real cost of debt-servicing goes up,” he said.

As a result, conventional government bonds such as US Treasuries are unlikely to hold many attractions for investors in the medium term, although inflation-linked bonds, such as TIPS, will be attractive, Mr Kasriel said.

Corporate bonds are relatively attractive investments because their yield spreads have widened significantly to price in the likelihood of high corporate defaults, he said.

As for equities, Mr Kasriel noted that US equities could start to recover in the second half of this year, because markets typically moved about six months ahead of an economic recovery, which he expects by the end of 2009.

Mr Kasriel said that comparisons with the Great Depression of the 1930s, which witnessed a US recovery between 1933 and 1937 despite serious policy errors such as protectionism, suggested that the US economy could recover now because central bankers had avoided the errors of the 1930s and there was as yet few signs of protectionism.

He pointed out, however, that the US economy went into a brief recession again in 1937 and unemployment never fell below double-digit percentage levels until the outbreak of the Second World War.