How Bad Will It Be? And What Should Policymakers Do?
SMITH BRAIN TRUST – For the U.S. economy, these are dark days. The social distancing measures aimed at stemming the spread of coronavirus have people and businesses closing their doors. Uncertainties about the future of the economy are high, and so are worries.
The situation is unprecedented, says William Longbrake, executive-in-residence in the finance department at the University of Maryland’s Robert H. Smith School of Business. In a recent interview with Smith Brain Trust, he shared his outlook.
Q: Is the U.S. economy now at the beginning of a recession (one that future GDP data will confirm)? If so, what is your outlook for the recession?
The economy is in recession. Starting date: March, possibly February.
Forecasters are busily updating projections for Q2 and 2020. JP Morgan projects -7.5% in Q2, which annualizes to -30%; Goldman Sachs projects -6% (annualizing to -24%) in Q2. The 2020 overall contraction has a wide range – all negative – depending upon assumptions about severity and length. The range spans from -2% to -4% (but estimates keep worsening), which would put it on a par or more severe than the 2008 Global Financial Crisis, when real GDP fell 4% over six quarters.
The outlook varies. Some expect the data to chart a “V,” which assumes that everything will pretty much return to normal by the end of the year. However, most expect an extended “U,” where recovery will start in Q4 and extend through all of 2021 and perhaps into 2022. There is a lot of uncertainty about the potential timing and pathway of an extended “U” recovery. It will depend upon how long the economy is paused by social distancing policies and how much damage accumulates during the pause. The longer the pause, the greater the economic damage will be and the longer it will take to repair the economy.
A policy debate is emerging “Lives vs. Livelihood,” where livelihood means the health of the economy. Obviously, there are tradeoffs.
Q: How deep will the economic contraction be?
Contraction will be immediate and will show up eventually in the April economic data. Whether the contraction deepens after April will depend upon whether social distancing lockdown continues into May and June. Economic damage to businesses and people will accumulate the longer normal economic activity is interrupted by social distancing policies. The longer it takes to begin to move back toward normal activity, the greater the risk of contagion impacts on other parts of the economy such as banks and credit markets through debt defaults.
This risk is being ameliorated to some extent by Federal Reserve 13(3) credit facilities and probably by the congressional emergency response package. But timing will be important and the devil will be in the details of policy responses. In short, there is still a high degree of uncertainty about the length and depth of the contraction.
Q: How will this downturn differ from previous ones? What are the sectors and industries that are likely to be particularly hard-hit?
Companies like Zoom and Amazon are doing extremely well, but cruise lines, hotels, the hospitality sector and Uber have been pummeled. Past recessions have largely been credit implosion events, which led to bankruptcies and layoffs. They usually were slow in developing.
Ordinary economic activity, such as entertainment and transportation, was impacted as unemployment rose gradually, but to a lesser extent. What is different this time is that social distancing and shelter in place policies have shut down large segments of the services economy. It is estimated that initial weekly unemployment claims will rise tenfold from 220,000 to 2.2 million in a couple of week’s time. As an example of how different this is: My dentist has filed for unemployment insurance. This has never happened in other recessions.
Q: The Federal Reserve already has returned to its zero interest rate policy and resumed buying commercial paper financial instruments. What other firepower does the Fed have in its arsenal and what is your outlook on the efficacy of those tools? Which, if any, monetary policy instruments will be most effective in responding to a crisis like the one at hand? What is your view of the likelihood of negative interest rates in the United States?
The Fed is ahead of the curve and appears close to having accomplished its objective as lender of last resort in stabilizing credit markets. Credit markets had been in the process of seizing up, but this now appears to be under control. Cutting interest rates isn’t of much help in the short run. Buying Treasury securities and mortgage-backed securities and doing so immediately in large volumes is providing much-needed liquidity to market participants. What happens when fear overtakes markets, as it did in the last week of February and the first three weeks of March, is that participants stockpile cash by selling highly rated securities. The Fed’s renewal of QE in bulk provides a much-needed buyer. In addition, the Fed has rolled out a series of 13(3) credit facilities. These credit facilities put the Fed at risk for losses and thus the statutory framework requires the Treasury Department to provide risk-absorbing equity through the Exchange Stabilization Fund. In the legislation that Congress is poised to pass, Congress will increase this fund considerably. The Fed will buy investment grade corporate debt, asset-backed securities, and ETFs (side note: at one point, many ETFs were trading 3% below intrinsic value because arbitrage, which normally keeps prices in alignment, had broken down because of lack of liquidity).
There is hole in the 13(3) credit facilities and that is the limitation to investment grade securities. This omits junk bonds, which could and probably will become a very serious problem since a huge component of the junk bond market is energy bonds, a large preponderance of which are headed to default because of the collapse in oil prices. It remains to be seen how much damage these defaults will inflict upon the economy.
Negative interest rates have been counterproductive in Europe. They create enormous problems for bank and insurance company profitability. The FOMC is on record as opposing negative interest rates, and I see no likelihood that this view will change because of the current crisis. Tellingly, the European Central Bank is not planning to make rates more negative.
Q: With the U.S. and other advanced economies entering this crisis at a time of already low interest rates, there is some speculation that the Fed and other advanced central banks might explore new extraordinary policy measures. Some of these include modern monetary theory, or even ‘mint the coin’ type of steps. Do you anticipate any such fundamental shifts or new tools coming from the Fed?
Modern monetary theory is generally misunderstood. Understood properly it advocates a traditional Keynesian response. When economic activity falls below potential, it posits that fiscal policy should replace lost income. This already occurs through automatic stabilizers such as unemployment insurance. It will be amplified in this crisis by rebate checks to individuals and low interest loans and grants to businesses to replace lost revenues. The $2 trillion package of fiscal measures about to be passed by Congress equals 9% of nominal GDP. Modern monetary policy also posits that when the economy strengthens and inflation begins to accelerate, Congress should raise taxes. This aspect of modern monetary policy tends to be overlooked. In the short run there will be an explosion of the U.S. government deficit but a substantial portion will be financing by Fed QE. Interest rates will remain low. These are necessary steps at the moment to prevent the current contraction from devolving into depression. But, the future consequences of a much larger accumulated federal budget deficit and a Fed balance sheet twice its recent size, while unknowable today, are likely to be very negative. No one is worrying about the future consequences at the moment.
Q: On the fiscal side, what stimulus measures should be adopted now, and at points in the future? Which, if any, should be avoided?
Because this is a recession primarily in the services part of the economy, caused by business closures in response to social distancing and shelter-in-place policies, the most effective fiscal measures will entail replacement of lost revenues and measures to help companies keep paying employees. This is not “stimulus,” which technically is about stimulating demand. We don’t need to stimulate demand, we simply need people to have the income to keep spending and live a normal life, and businesses need to replace lost revenue to meet operating expenses and pay employees. The $2 trillion fiscal package has some of these features, but it is questionable how well targeted the measures are to where it is needed most. There is some question as to whether the amounts will be sufficient. And, later there will be the problem of arranging implementation and the timeliness of response. The need is immediate because of the abruptness and pervasiveness of the shutdown. A delay of a few weeks seems likely and could be very troublesome.
Q: What lessons from previous crises and recessions do you see as particularly instructive in this time?
This is a very different kind of recession; one stemming from a mandated shutdown in economic activity, which can be reversed. Its impact is primarily on services. So there aren’t many applicable lessons from the past. The lessons that do exist include rapid response of policymakers. This is occurring both for monetary and fiscal policy. Another lesson is to design policy to deal with and target specific economic soft spots and to do so as quickly as possible to prevent damage from accumulating – the deeper the hole gets, the harder it becomes to get out of it. While this is an obvious lesson, it is hard in our system of government and complex economy to craft and implement quickly highly targeted responses. We tend to fall back on more general remedies, such as sending every adult (except for the rich) a check. The reality is that many won’t need this check, but many others will need more. A more effective policy probably would be to limit unemployment and replace a substantial portion of lost wages directly, rather than sending out checks. But this is complicated and we are unprepared to design and implement such a targeted policy quickly and effectively.
Q: What advice do you have for investors, consumers, and potential home buyers?
I have been asked about whether this or that person should sell their stocks. My answer has been “No.” For one thing, with the stock market down 30%, it is late. Of course, matters could get worse depending upon how social distancing policies are handled in coming days and how much more economic damage occurs. However, there are signs that the Fed’s responses are stabilizing markets and that the fiscal package, flawed as it is, will be more help than hindrance. Key in coming days will be data on new COVID-19 cases with a likely favorable market response as the rate of acceleration in new daily cases reported slows. A shift in policy from lives to livelihood would probably be constructive for markets. However, it will be important that such a policy shift be carefully constructed to limit a potential re-acceleration in new cases once social distancing programs are relaxed. This would involve extensive testing, quarantining, and probably retaining strict social distancing measures for those most at risk, which generally are those with complicated health histories (which is correlated with age, but not exclusively).
Because of Fed monetary policy, it is my belief that when the economy recovers, interest rates will stay extremely low and near zero. Some may worry that inflation will break out, but if that is a problem, it won’t show up for a very long time. I say this because we are not really stimulating the economy, we are replacing lost income. When matters return to a semblance of normal, lower interest rates will support high stock market valuations. So, there is considerable potential that stock prices will return to or exceed previous highs within the next year or two.
For homeowners, this is a good time to refinance. For potential homebuyers, this is probably not yet the best time to buy. While I’m not particularly worried about a precipitous fall in home prices – this is not like the housing bubble, when prices were clearly overvalued because of excessive speculation – there is a chance that prices will soften a bit because of the recession. But I expect rates to stay low and therefore, I see there being time later to enter the market and to do so when individual employment and income opportunities stabilize.
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