The economic disruption caused by the outbreak of the coronavirus will be sharp and likely to linger for some time. The price war that has broken out between the Saudis and Russians in oil markets brings a new, more difficult policy twist to the crisis. It all adds up to a series of supply, demand and financial shocks that now threaten normal life and commercial activity throughout the global community.
For many policymakers and corporate leaders, the notion of a supply or demand shock will seem quaint and mystifying. Over the past few weeks, I have had the same basic question put to me: What is a supply shock and why should I care? Economists will need to explain in clear and simple detail what this is and what it means.
The policymaking community needs to move swiftly and overwhelmingly, and be willing to sustain the response.
The policymaking community needs to move swiftly and overwhelmingly, and be willing to sustain the response to mitigate the worst of the shocks for longer than they would otherwise prefer to admit. This will require imaginative and creative actions from an otherwise risk-averse set of policymakers.
To address the most challenging aspects of the crisis, policymakers need to move quickly to get cash into households. They will need to provide trade and bridge financing to small and medium-size enterprises that will suffer through no fault of their own. In addition, this all needs to be done over the next few weeks to avoid rising unemployment, soaring bankruptcies and recession along Main Street.
We acknowledge that the impact of the virus will vary within the economy. Areas with modern health infrastructure and broadband to support telemedicine will be better off. Yet areas with deficient health systems are at risk of a loss of life and disruption to industrial sectors that are unprepared for the crisis.
These supply and financial shocks will turn swiftly into a demand shock — all of which have the potential to disrupt the normal flow of business and severely damage the economy no matter where in the industrial ecosystem one works, invests or manages.
Put simply, a supply shock means that manufacturers don’t have the parts to produce final goods, which results in stores no longer having goods to put on their shelves. The best example of a recent supply shock was the oil-supply shocks of the 1970s. Production bottlenecks, shortages of heating oil and gasoline, long lines at the gas station and rising prices followed in their wake.
As the flow diagram above illustrates, the coronavirus outbreak is an exogenous shock that — because of the need to engage in self-distancing and remote working — is causing the current supply shock.
The loss of output from Asian supply chains is causing a disruption in the supply of goods used at earlier stages of production and intermediate goods required for production of final products. The lack of product then causes declining revenues and earnings, as well as a drop in the well-being of consumers.
Interdependence of products along the Asian supply chains will result in a loss of income across the global economy. For example, as factories are closed either for health reasons or because of a lack of intermediate parts necessary for production, activity at American seaports will continue to fall. The result is a reduction of hours or layoffs of shipyard employees. In addition, this will affect the truckers who deliver those goods to warehouse employees and the merchants whose income is derived from selling goods and services to those employees.
That lost income among consumers and reduced revenues among firms require a focus on alternative supply chains, alternative modes of transporting goods and lines of liquidity to bridge the crisis. The large, globally active multinational firms will be able to use the deep and broad capital markets of the U.S., Europe and Japan. But small and medium-size firms will require targeted aid from the federal government.
The Covid-19 supply shock will lead to a series of a demand shocks; this is already taking place in the oil complex. The demand destruction can be permanent and the risk of a supply shock turning into a demand shock is that the recovery can be elongated.
Should there be a period of enhanced self-distancing or outright quarantining of portions of the domestic economy along the Pacific Coast, for example, one should expect a sharp drop in demand for Asian goods and services even as a reduced supply of those goods and services reflects the status quo. This will include everything from demand for local products to demand for imported products and goods made in Asia by U.S. and European corporations (for example, iPhones and Volkswagens) that will affect earnings and equity share prices. Of course, sharp declines in equity and other asset prices will also lead to financial shock that carries with it significant implications for household spending.
In response, U.S. households would be expected to begin tightening their belts by cutting down on nonessential purchases. These include eating out, vacations, airline tickets, baseball games and concerts. There is already a nervous reluctance to be exposed to potential disease carriers, whether on a subway car or at the local tavern. A drop in consumer spending within an economy that is based on services and non-essential spending has the potential to drag down the entire economy.
This is why we are not among those anticipating a “V-Shaped” recovery following the shock. Rather, we expect a recovery that will look close to the “Nike Swoosh.”
While it is possible that the supply and demand shocks will eventually be resolved once the virus is contained, the subsequent shock to the global financial system is likely to have a longer-lasting impact. First and foremost will be the negative wealth effect on investors and society as a whole.
Asset volatility will cause upper-income households to pull back on spending.
Global equity markets collapsed in unison during the week of February 28, obliterating this year’s gains. And although only a small portion of the population actually invests in the equity market and although the stock market is not the determinant of economic growth, the public at large knows whether the Dow is up or down each day, and that can play a part in household purchasing decisions. In short, the U.S. economy is overexposed to a small concentration of workers at the upper end of the income ladder.
Asset volatility will cause upper-income households to pull back on spending. Roughly 40% of households are responsible for 61.4% of overall spending. Because these upper two income quintiles are sensitive to volatility in asset markets, policymakers, investors and firm managers should prepare for a downturn in household spending. Asset volatility in the fourth quarter of 2018 caused household spending to slow from 3.5% to an average of 1.2% in the following two quarters.
Perhaps more important for the arc of long-term growth is the willingness of borrowers and lenders to invest. Investment decisions must now include: increased uncertainty regarding the potential for another attack on the global supply chain, a loss of confidence in the economy to withstand another attack, and a loss of confidence regarding the infrastructure for dealing with this and future crises. This, in turn, cries out for a robust and sustained policy response from the monetary and fiscal authorities.
Monetary policy options
The result of a financial shock is a drop in the propensity to invest. Why invest if the endeavor won’t be profitable or if the returns on the loan are too low to compensate for the risk of not holding cash.
The willingness to invest is an essential component of growth and therefore within the Federal Reserve’s mandate to maintain full employment and price stability. This can best be achieved within a climate of financial stability and with the certainty that the central bank will adjust its policies to counter disruptions to that stability. We anticipate that lower interest rates, regulatory forbearance, liquidity commitments and rising asset purchases will be necessary to stabilize the economy during and in the aftermath of the shocks.
Most important, the series of shocks affecting the economy will cause the real neutral interest rate to fall. At the end of December 2019, just before the onset of the crisis, it stood at 0.5% and it has probably declined sharply since. What this means is that the federal funds rate is probably too high and restrictive for growth, even at such low levels. Expect to see more rate cuts and a return to the zero boundary in the near term.
The shocks affecting the economy will cause the real neutral interest rate to fall.
The modern arsenal of monetary policies includes the adjustment of short-term interest rates, which are essential for business transactions, and purchases and sales of long-term securities to affect long-term interest rates necessary for fixed investment. The Fed cut rates by 50 basis points on March 3 and the market has priced in another 50 basis point cut on or before its March 17-18 meeting.
And in contrast to the 1970s oil shocks, the Fed is probably not as concerned about a future bout of inflation. The price war taking place among OPEC+ countries carries with it price dynamics that imply falling business investment and deflation.
The Fed is most likely more concerned about a deflationary shock surrounding a sharp decline in demand and the resetting of the yield curve lower, implying a much slower pace of growth and rising unemployment going forward. This shock is occurring in an economic climate that was already slowing. There is a global supply of labor that will continue to exert downward pressure on wages, and Europe and the U.K. have suffered through a decade of austerity that has already reduced demand.
A supply shock complicates the picture, nevertheless. Neither patching up the supply chain nor protecting equity-market profits is within the central bank’s purview. Thus, monetary authorities need to act. However, they are a necessary but not sufficient condition to stabilize the economy. The fiscal authority will need to step forward.
There are some measures to be considered:
- The Fed can open lines of credit. As with the financial crisis — when liquidity in the financial markets dried up – the Fed can open lines of credit, this time for businesses that can no longer meet payroll requirements.
- The Fed can instruct banks to provide forbearance. This would help borrowers unable to meet obligations.
- The Treasury can begin buying physical assets of corporations. The government did this when it saved the auto industry during the financial crisis. Yet, under the Federal Reserve Act, it cannot purchase corporate debt or equities should the credit and stock markets freeze up. That would take an act of Congress.
There is no shortage to the imagination of the economists who reside inside the central banks. If necessary, the Fed can engage in temporary yield targeting, capping of yields or targeting the price level and enhanced forward guidance. In our estimation, none of those will be required to stabilize the economy around this crisis. Should there be a more severe breakout of the virus that requires effectively shutting down large sections of the economy, though, those ideas, in addition to negative rate policy, will be part of the policy playbook going forward.
In the end, the consensus among central bankers is that monetary policy can do only so much to mollify a supply shock. Interest rates are already too low, leaving little or no room for rate cuts to have a substantial effect. There is universal agreement that it is up to the governments from Bonn to Washington to provide a fiscal response to the supply shock.
Fiscal policy options
The government can help the economy by providing employment and guaranteeing income for affected communities, which would increase the ability of households to maintain normal levels of consumption. The first tranche of $8.3 billion in supplemental funding to combat the coronavirus was passed and signed into law. The scientific and medical communities have said that they need $15 billion to properly address the crisis. That should be made available as soon as possible. This is no time for fiscal conservatism.
We propose the government plug the holes in household balance sheets by expanding the social safety net (such as extended unemployment benefits and free access to testing and health care) or guaranteeing employment should layoffs occur. Simply guaranteeing a $1,000 per month income to each adult during the crisis would probably go a long way toward maintaining demand and might be the most cost-effective method of getting cash in the hands of consumers.
A bill providing $8.3 billion to combat the coronavirus was signed into law, but it’s not enough.
A second option would be a temporary payroll tax holiday to bolster consumer bottom lines. During the financial crisis, the federal government reduced the payroll tax from 6.2% to 4.2%.This could be done swiftly and easily. The key would be to keep it in place until the crisis abates and then unwind it in a gradual and orderly fashion.
Should there be a much more profound public health emergency, it will require the fiscal authority to cooperate with the monetary authority to construct a temporary lending facility for Main Street small and medium-size businesses.
Whatever the case, dropping tariffs to zero or imposing a temporary tariff holiday to jump-start global commerce once the risk passes makes perfect sense given the hit on trade that is taking place.
Whatever is done in response to the crisis, it is critical that it not be a backdoor bailout of the large firms or Wall Street, or provide an opportunity to engage in crony capitalism.
It is ironic that the success of the global supply chain and the interconnectedness of societies — from Asia to Europe to the Americas – has within it the potential to reverse the gains derived from peaceful competitiveness, comparative advantage, collaboration and the efficient production of goods. But the coronavirus respects no borders or walls. Cooperation among the fiscal and monetary authorities and nations will be required to move past the most unexpected of outlier economic and social risks.