The economy is recovering, consumer confidence is rebounding and Obama just snagged the Nobel Peace Prize. Good times. Not so fast, says Nomura Securities International global chief economist Paul Sheard. U.S. and European economies are still quite "vulnerable," he warns. His big worry is something that few economists these days are talking about: the risk of outright deflation. Deflation, of course, occurs when the inflation rate goes negative, making it harder for central banks to stabilize an economy, because as Sheard explains, it's harder to start a fire then to tamp one down.

"Deflation is a bigger risk than inflation because it's much harder to get an economy out of deflation than inflation," Sheard said in an interview with DailyFinance. "You can have a burst of inflation and the central bank can always squeeze inflation out of the system. Deflation is different because deflation becomes entrenched."
While deflation may sound good for consumers -- we can buy more stuff with the same amount of money -- it's bad for the economy because growth slows and demand wanes as consumers grow cautious. Deflation makes it difficult for central banks to stabilize an economy because controlling interest rates is designed to control inflation, not deflation. As gold rallies to record levels and Australia raised interest rates this week, investors worry inflation will kick in. But Sheard says the larger concern is deflation.

Whereas inflation can be reigned in, deflation would present a more difficult problem, Sheard explained. "If a mule is galloping, you can reign it in," he said. "If a mule is refusing to budge you can't get it to budge. That's inflation versus deflation in a nutshell." If deflation occurs, consumers become pessimistic and don't spend or borrow, he said.

Sheard says inflation isn't a bad thing in the short term, as long as central banks, such as the U.S. Federal Reserve Bank, keep it in check. Sheard recently spoke with DailyFinance in a telephone interview from his office in New York about the U.S. economy, housing and his recession outlook. Edited excerpts of the conversation follow:

DailyFinance: If you had to guess, do you expect another economic crisis soon?
Sheard:
We don't think there's going to be another crisis or serious relapse into recession, but it's very hard to see a V-shaped recovery, which is what you'd normally expect after a recession. Usually the deeper you go, the faster you bounce back. The recent crisis is a once or twice in a century kind of recession.

Is the U.S. economy still in trouble?
The problem with the U.S. is consumers. U.S. households are not as wealthy as they thought they were. Home prices rose for many years with the expectation they would continue to rise. Home prices in the U.S. have fallen 35 percent and that does a heck of a lot to people's assessments as to what their lifetime wealth is actually going to be. So homeowners have reassessed and said "I must trim my sails a bit here." If everyone does that, even a little bit, it ends up being quite a drag on the economy.

How about housing?
The housing market we think is bottoming, but there's still a lot of fragility. You can certainly imagine a turn of events where housing prices begin to fall again. And with unemployment at 10 percent and foreclosures at a historic high -- that would be a very ugly scenario. The commercial real estate market is still in a precarious situation. The impact of consumers having borrowed when they felt quite wealthy due to higher home prices, only to discover they are not quite so wealthy, truly is having a profound effect.

What's your forecast for economic growth?

We are expecting in this quarter, annualized growth of about 3.5 percent. For the quarter itself, that's not bad, but after that, we're seeing growth taper off again to two to 2.5 percent (annualized) by the second-half of next year. If you applied normal, historic metrics, the U.S. should be growing at 5 to 6 percent for the next two years. That's simply because it has fallen so far that to get back to full employment, you need to grow above potential for a couple of years to squeeze that slack out of the system. We think that's very unlikely. It's going to be closer to 2 to 2.5 percent over the next couple of years and probably extending beyond that.

Any reason to be optimistic?
If you're banging your head against the wall, it feels a lot better when you stop. So the very fact that the economy is no longer in free fall, and is bouncing back, is positive.

What kind of economic recovery do you expect?
There is a camp that is looking for a V-shaped recovery, and I think that's very unlikely. I see more of a drawn-out, upward-sloped L-shaped recovery. It's a V-shaped recovery where you taken the right-hand part of the V and pulled it way down towards the floor.

How did we get into the recent economic mess so quickly?

What happened, basically, was, you had a housing bubble and credit bubble, the bubbles burst and it caused the financial crisis in the economies that were directly exposed, which is basically the U.S. and Europe. That caused a collapse in demand in the U.S. and that ricocheted around the world, causing the collapse in exports and that hit everybody.

Anthony Massucci is a senior writer and columnist for DailyFinance. You can follow him on Twitter at hianthony.

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