The policymaking community needs to move swiftly and overwhelmingly, and be willing to sustain the response.
Supply shockPut 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.
Demand shockThe 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.”
Financial shockWhile 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.
Monetary policy optionsThe 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 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.
Fiscal policy optionsThe 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.