Transition Worries

The market’s implied inflation forecast continues to hover around the 2% mark, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries. That’s a sign that the crowd is feeling relatively optimistic about the economy’s prospects. In the New Abnormal, lower inflation expectations are a sign of trouble. The fact that inflation expectations appear to be stabilizing is an encouraging sign… if we can keep it.

The bar was set pretty low, of course. Expectations have been quite dim in recent months for a resolution of the eurozone crisis, to cite one challenge. Meanwhile, prospects for the U.S. economy looked increasingly soft through the summer and early fall. But things are looking up, or at least they’re no longer looking down, which is reflected in the market’s inflation outlook.

Is this the calm before the storm? No one really knows, in part because so much depends on political decisions—here and abroad. In Europe, leaders are scheduled to hammer out another agreement tomorrow on solving the debt crisis. Hope springs eternal. The “solution,” according to some, is imposing more fiscal austerity on the Continent’s economies. There’s already quite a bit of that blowing through Europe, but the German push for more appears to have the upper hand. For good or ill, tighter fiscal policies appear likely.
A number of analysts take a pessimistic view of the unfolding events in Europe. Austerity in a time of severe economic stress is thought to be exactly the wrong policy. “Public-sector cutbacks today do not solve the problem of yesterday’s profligacy,” warns economist Joseph Stiglitz. “They simply push economies into deeper recessions.
Here in the U.S., there’s a surplus of uncertainty about what happens next with the budget negotiations in Washington and how the outcome will affect the latest revival in economic momentum. “The problem heading into 2012,” writes James Cooper at the Fiscal Times,

is the fiscal drag on economic growth from expiring stimulus programs, including the last vestiges of the 2009 Recovery Act and this year’s temporary stimulus from the cut in payroll taxes and extension of unemployment benefits. Economists at J.P. Morgan estimate that, if all these programs expire on Dec. 31, as scheduled, the total fiscal drag on real GDP growth in the first half of 2012 would add up to 2.6 percentage points on the average annualized growth rate of GDP, with the biggest hit in the first quarter.

Nonetheless, the crowd is feeling better these days. U.S. stocks have rallied in recent sessions and the year-over-year change in the S&P 500 is positive once more, if only slightly. Recession risk doesn’t appear to be getting any worse, although it’s not yet clear if it’s receding for the U.S.
Europe, however, continues to falter. Italy’s economy in particular seems to have already fallen to the dark side of the cycle.
We’re in a transition once more. But transitioning to what?