• The recovery remains on track, but is now entering a more critical phase where the boost from inventories, fiscal policy and normalisation of financial conditions is fading.
  • Going forward, the fate of the recovery will depend upon the strength of underlying demand. In this respect, a turnaround in jobs remains essential for the economy to settle on self-sustained recovery path.
  • The longer-term outlook remains one of moderate growth as tough fiscal consolidation and financial regulation lie ahead.
  • Inflation is heading lower with headline CPI hovering around 1.6% from mid-2010 and core inflation bottoming at 0.5%. Strong deflationary forces will keep core inflation subdued throughout 2011.
  • Monetary policy will be tightened in small and gradual steps. The first rate hike is likely to arrive late this year and reflect a desire to move away from ZIRP. Fundamentals may lead Fed to pause in 2011.

Slower, but sustained, growth ahead

The economic recovery is on track with ongoing, but gradual, signs of progress among consumers and businesses, but with some more erratic developments in housing. In Q4 09, the economy delivered its second positive quarter on growth following the recession, with GDP expanding at 5.9% q/q AR. Indeed this turned out to be even stronger than we had forecast in December’s Global Scenarios, the main reason being a faster-than-anticipated stabilisation of inventories.

Given this front-loaded impact from inventories, the short-term growth profile is somewhat lower. The forecast is now for a 3.5%q/q AR growth rate in Q1 slowing to 2.5-3.0% for the remainder of the year. The forecasts for annual growth for 2010 and 2011 remain unchanged at 3.2% and 3.0%, respectively. Hence, we still expect a moderate recovery compared with historical standards and relative to the depth of the recession.

The boost from inventories is over. Now what?

There is little doubt that the majority of the boost from the inventory cycle has already arrived. A stabilisation in inventories will add around 0.25pp to annualised growth in H1, while a return to a normal post-recession pace of inventory building could boost this estimate to 1pp. In any case, this is minuscule compared with the 2.5pp boost that arrived in H2 09.

The concern is now how the recovery should proceed. Domestic demand growth is still running subpar and the impact of fiscal stimulus is fading. Furthermore, much of the positive snapback effect on growth from improving financial conditions has already arrived and there has been renewed weakness in housing data lately.