U.S. Recession on Horizon, Morgan Stanley's Xie Says (Update2) By Hans van Leeuwen and Haslinda Amin http://www.bloomberg.com/apps/news?pid=20601103&sid=aLaisrwcN6ag&refer=us Sept. 15 (Bloomberg) -- The U.S. economy may fall into recession in 2008 as ``inflation pressure'' drives up borrowing costs next year, Morgan Stanley's chief Asia economist Andy Xie forecast. Xie said the U.S. Federal Reserve policy makers have so far persuaded investors that they will contain inflation, helping keep yields on 10-year notes below 5 percent. U.S. consumer prices will increase more than expected, Xie predicts, prompting a bond market selloff. ``We're headed for stagflation because the bond market believes the Fed,'' Xie said in an interview today on the sidelines of the International Monetary Fund annual meeting in Singapore. ``Recession will happen when the bond market sees through the Fed and sells off. People will have nowhere to borrow money anymore.'' Xie's view is darker than the predictions published yesterday by the IMF, which also expects a slowdown in the U.S. He says that inflation will persist because of rising prices in Asia, whose growth will fuel the global expansion next year. ``Inflation is not going away at all,'' said Xie. ``It's coming from land prices in Asia, and that's feeding into production costs.'' Rising Risks The IMF yesterday said that inflation, oil prices and the risk of an abrupt drop in U.S. housing prices the strongest global expansion in three decades. The fund cut its prediction for U.S. growth next year to 2.9 percent from the 3.3 percent it forecast in April. That would be the weakest since 2003. Morgan Stanley's New York-based chief economist, Stephen Roach, said that while he didn't share Xie's view, the ``odds of a U.S.-led global recession are rising in the 2007-08 period and cannot be taken lightly.'' David Rosenberg, chief North America economist at Merrill Lynch & Co., forecasts a 45 percent risk of a U.S. recession next year. U.S. government 10-year bonds are yielding 4.77 percent and consumer prices rose 4.1 percent in July from a year earlier. The average rate on a 30-year fixed mortgage was 6.32 percent last week, close to the lowest since March. ``The bond market is not sustainable because inflation pressure is quite strong, so at some point next year the bond market will go down and the yield will go up,'' Xie. ``At that time, the U.S. economy will be in a tough spot.'' The Federal Reserve left interest rates unchanged at 5.25 percent at its last meeting on Aug. 8 after 17 consecutive increases since June 2004. The U.S. accounts for more than a quarter of the world economy. Chinese Growth Asia may be insulated from a U.S. recession at first, as China's high savings rate could fund continued investment in the world's fourth-largest economy. ``But if the U.S. stays down for several years then China will also slow down, because in the end Chinese liquidity is based on exports,'' Xie said. The IMF forecasts the global economy will expand 5.1 percent this year, slowing to 4.9 percent in 2007. Both forecasts are 0.2 percentage points higher than its April estimates. Growth was 4.9 percent last year. U.S. economic growth slowed to an annualized rate of 2.9 percent in the second quarter, after expanding 5.6 percent in the first quarter. China's economy advanced 11.3 percent in the quarter from a year earlier.