Update on recession/deflation risk in the US and euro risk in Europe

- Rising risk of recession and deflation in the US
• "Fears of a double-dip recession and the risk of deflation have risen appreciably. While our own baseline forecast has not moved that far, the downside risks have clearly increased. We review the recent US economic news and what can be gleaned from movements in financial indicators, indexes of leading indicators, and recession probability models."
• "We find that recession probabilities have in some cases risen close to levels that have in the past been associated with ensuing economic downturns. While the evidence on this point is mixed, the risk is heightened by two policy factors: (1) a Fed that is running very low on available policy stimulus measures and (2) fiscal policy that is scheduled to turn substantially contractionary in the quarters ahead, with at best mixed signals from Washington on the prospects for relief on that score."
• "With inflation low, economic slack high and possibly rising, and longer-term inflation expectations showing some signs of wavering, the possibility of dipping into deflation grows larger. We judge the risk of deflation to be somewhat greater than that of a serious double-dip recession."
- Euro crisis: Mission not yet accomplished
• "Policy makers so far have treated the euro crisis as a liquidity crisis while market participants have tended to believe that at the heart of the euro crisis is the insolvency of one or more euro area states. Hence, measures taken so far have not been able to reduce tensions in EMU bond and money markets."
• "To reassure markets authorities need to develop a scheme that can deal with an insolvent state within EMU, if only as a contingency plan in case their assessment that adjustment will be successful proves wrong. The key for such a scheme is to allow a sovereign default in EMU at minimum cost for tax payers by building an efficient safety net for investors in EMU government debt."
• "Without such a scheme, failure of the deficit countries to adjust as promised could turn into a life-threatening event for EMU. But it will probably take a return of the euro crisis and a clear and present danger of a collapse of EMU to trigger the construction of such a scheme. We expect this to happen within the next one to two years."

DeutscheBank Global Economic Perspectives 20100901

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