Forex Flash: Europe trend growth below "Great Moderation" – Merrill Lynch

After running several scenarios (one hypotheses on the speed at which investment recovers and whether it can reach pre-crisis levels; and another taking into account the impact of higher unemployment (and the capacity to reduce it), demographics and the quality of education) and looking at the fundamentals behind an economy’s capacity to grow (investment in physical and human capital, and the ability to innovate and embed innovation into business) and capacity to innovate, the overall result is that the capacity to grow (trend growth) remains below that observed during the “Great Moderation” (1995-07), according to BofA Merrill Lynch analysts.

"Having said that, assuming European productivity converges with that of the US, we expect healthy trend growth after 2015", they wrote, pointing to elevated deflation risks, due to steep loss in cyclical production. "Consequently, in our exercise, we assume the negative output gap that opened up in 2008 remains large throughout the crisis period and closes only by end-2014 - an assumption in line with most international organizations’ projections", they continued, expecting inflation to decelerate to end-2014. In case inflation decelerates faster, ECB would likely "need to cut rates further and possibly experiment with more unconventional policies".