THOUGHTS ON WHERE WE ARE / NOURIEL ROUBINI GLOBAL ECONOMONITOR ( HIGHLY RECOMMENDED READING )

Thoughts on Where We Are

Nouriel Roubini

Oct 2, 2009

Editor’s Note: The following are excerpts of a briefing this week Nouriel Roubini delivered to RGE Analysts in New York.

Roubini on ‘U’ and ‘V’ Shaped Recoveries

I was thinking about anemic growth, which I’ve been saying means 1-1.5% growth next year, which denotes a U-shaped recovery. But what if we see 2% growth next year for a while? 2% is better than 1.5%, but implies that the output gap is still rising, assuming that potential GDP and unemployment are also still rising. This happened in the 2002 recovery for a few quarters. So if growth is closer to 2% rather than 1% for a number of quarters—and potential growth is 2.75% —to me that’s still a U-shaped recovery. Even if you go to potential growth at 2.75%, that’s not enough to mop up all that excess slack in the output gap and labor markets for a while.

You need to grow faster than potential for a while in order to reduce the output gap. If you go back to potential growth, the output gap might not be widening again, but the difference between that level and potential stays as a permanent hole. If instead you grow faster than potential then you reduce that gap and you also reduce the slack in labor markets. But if you grow below potential the labor markets will be weaker—and weaker means rising unemployment rates.

So I think we have to be open to the idea that things in 2010 can be better, but it might still be a U-shaped recovery. If we go into 2010 with 3%+ momentum and in 2010 the economy grows 3% to 4%, meaning above trend, then clearly we are in a V-shaped recovery. But if we go to 1.5% to 2%—even if its 2%—that to me looks like a U because we would have to be at least at potential, and probably more, in order to reduce all that labor market slack.

Roubini on the Federal Reserve Raising the Fed Funds Rate

My view has always been that I don’t think the Fed will even think about raising rates until the end of next year, and more likely 2011, even if we have a V-shaped recovery. Markets were pricing in a rate hike as soon as January or February, a year earlier than I think is likely. This may depend on how robust the recovery is and on whether it is jobless or not.

By some standards, our last recovery from recession was V-shaped, if you think of it in terms of GDP growth. But the Fed kept cutting rates until the middle of 2003 and then kept them at a low level of 1% until mid-2004 before beginning a process of tightening.

You’d have to really have a meaningful V-shaped surprise—that is consistent and resilient—for the Fed to consider raising rates as soon as Q1 2010. Conceptually, in order to raise the fed funds rate you would first need to mop up all the excess liquidity (base money), though some people argue that is unnecessary as now the Fed could use interest rates on reserves as a monetary policy tool. Do we need monetary policy to target asset prices? We now have banks that can borrow at zero interest rates and some point out that this might be the beginning of a new bubble. You can use the fed funds rate to target growth and inflation and assign regulatory policy to avoid another asset bubble. Even if you are doing regulatory policy, you are doing micromanagement of credit flows, but ultimately the only tool that has a broad base and signals to everybody a higher cost of capital is an increase in the fed funds rate.

Some ask whether we could find ourselves in a situation in which we have a problem of growth and inflation, if we assume a V-shaped recovery and rising inflation expectation given the unprecedented policy measures. But there are essentially two ways you can get inflation. One is if the economy overheats and we will be lucky if we have that problem (in that case the slack in the labor market would be eliminated and unemployment could go below its natural rate). The other is a situation in which you have output falling but inflation is going up. A stagflationary situation could arise from an oil shock for example. Stagflation needs a weak economy and a supply side shock, the chances of that happening are more related to geopolitical risks than economic fundamentals.