The Federal Reserve has moved the federal funds rate to the zero bound in a series of swift responses to the outbreak of the coronavirus and the market’s anticipation of the shock to economic growth and market stability.
The Fed will most likely reach deep into its toolkit in 2021 with a rarely used policy called yield curve control.
The Fed has put together nine different lending facilities and put forward liquidity commitments that run in the trillions. While we expect the Federal Open Market Committee to restate its commitment to keeping short-term rates as low as possible for as long as necessary, there will be more policy innovation coming in the near term.
This will most likely result in a rarely used policy called yield curve control in 2021 once the central bank can ascertain how the battered economy is responding to the government’s fiscal and monetary policies.
Yield curve control, while controversial, was used during World War II and in its aftermath to complement a period of large government deficits relative to gross domestic product.
Yield curve control targets long-term interest rates at a specific level that is then achieved by a central bank buying or selling as many bonds as necessary to hit that target rate. If the Fed decided that the yield on the 10-year U.S. government security was going to be .50%, then the central bank would have to commit to meeting that target.
The objective is to stimulate overall economic activity through an easing of financial conditions. Essentially, lower interest rates on mortgages, auto loans and corporate debt — a real risk going forward — to encourage spending by households and investment by businesses.
The Federal Open Market Committee “expects to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals. This action will help support economic activity, strong labor market conditions, and inflation returning to the committee’s symmetric 2% objective.”
Given the magnitude of the shocks that the economy is absorbing, the probability of inflation in the near to medium term is low, and the central bank has maximum degrees of freedom to support employment and economic activity without dislodging inflation expectations.
How long do the authorities anticipate that process to take? The Congressional Budget Office projects that real gross domestic product will have collapsed by 5.6% in the fourth quarter of this year, before rebounding to only 2.8% growth by the end of 2021. That 2.8% growth will be relative to the low base of the fourth quarter of this year, which is not much relative to previous recoveries from recessions.
Without prior knowledge of the Fed’s or CBO’s projections beyond 2021, we are assuming that the shock to the economy will not be limited to a few months this spring.
Given the uneven response in providing aid to small businesses impaired by the virus and the downturn by the federal government, we assume that the loss of a multitude of small businesses that drive the economy and the overall loss of unrecoverable income will inflict long-term damage to the labor market, household income and consumer spending.
The recoveries from the Great Depression and financial crisis were arduous. and this current recession has the makings of a similar results.
For instance, the unemployment rate hit 10% in 2010 after the financial crisis worked its way through the labor market. The CBO is anticipating an unemployment rate of 11.4% and 10.1% in 2020 and 2021. By our estimates and based on the flood of initial jobless claims in March, we see the possibility of unemployment rates anywhere from 14% to 30%, depending on the severity of the health crisis.
Because there are so many unknowns regarding a potential vaccine and the depth and breadth of the virus’s effect on the global economy, we have shown GDP growth and the labor market at its most optimistic, with the trends returning to the CBO’s pre-virus paths. And the same for monetary policy in the figure below, which suggests that the Fed will be able to push short-term rates back to pre-crisis levels if the economy were to snap back as if by magic.
We anticipate further Fed asset purchases, with legislation allowing the purchase of non-federal debt of distressed corporations and the capping of interest rates, among other monetary policy initiatives. But given the reluctance of Congress to supply a sufficient fiscal response to the financial crisis, and given at least a year for a safe vaccine to be developed, we anticipate further losses in innovation and productivity.
This will have long-term negative effects on potential output at the start of another arduous recovery from a recession or depression. That implies — at best — a continuation of so-called “Secular Stagnation” that gripped the economy for the decade after the financial crisis.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
