Before the COVID-19 pandemic, the U.S. economy was clearly slowing down. It may seem like another era – before the economic toll of the coronavirus had set in and the equity markets collapsed. But even in that period of relative calm, conditions were ripe for the Fed to address a slowdown.
The probability of deflation is rising even though aggressive monetary and fiscal policies have been adopted.
Today brings a different dynamic, and a more immediate threat. The magnitude of the economic shocks strongly implies that the probability of a general decline in prices — a dynamic known as deflation — is rising. This is happening despite the $3.4 trillion in liquidity commitments put forward by the Federal Reserve and $2.89 trillion in fiscal support passed by the Congress to address the pandemic.
This stands in contrast with the assessment of many that the aggressive fiscal and monetary policies recently adopted will lead to general inflation or even hyperinflation. We think that such conclusions are erroneous and not in touch with reality of the toll that the pandemic is taking on the economy.
The idea of deflation was widely discussed during the financial crisis of 2008-10. But the size and scale of the Federal Reserve’s actions taken during the crisis has been widely credited as avoiding deflation.
The wages factor
\One other idea that has been studied is the way that firms respond to declines in demand – known as downward nominal wage rigidity. If employers are unwilling or unable to reduce wages in dollar terms, they have to reduce the number of employees, which in turn causes rising unemployment, declining output and “pent-up deflation.”
Although we are still in the early stage of pandemic economics, it is quite clear that the shock to the labor market is going to be the largest since the Great Depression. In our estimation, the shock to the labor market in the current crisis will include a period of unemployment that will include no fewer than 35 million people and quite possibly more than 40 million before the crisis crests. To put that in perspective, the economy generated 21.6 million jobs during the 2010-2020 cyclical expansion, the longest in U.S. history.
For this reason, it is difficult to make the case that downward nominal wage rigidity, which prevented an outbreak of deflation during the financial crisis despite unemployment rising to 10.1%, will hold under current and evolving economic and labor market conditions.
Unemployment insurance just about guarantees that wage stickiness will certainly hold down the income ladder — 16 million in continuing claims at $1,000 per week translates to $16 billion, or roughly 8% in wages and salaries — should be sufficient to guarantee it. But once unemployment insurance is relaxed or ended, it is difficult to make the case that there will not be a haircut in wages and extreme income volatility up the income ladder.
The shocks that firms are experiencing strongly imply that revenue losses expected over the next six months will leave firms with little choice but to reset wages in the near to medium term. The RSM Middle Market Business Index for March implied that 38% of executives reported that gross revenues declined in the current quarter and 45% expected them to decline over the next six months
In fact, early in the crisis, our March survey found that 16% of executives reported a decline in compensation in the first quarter and 17% expected declines over the next six months.
It is hard to believe that as firms come to grips with true nature of the crisis — followed by declines in household consumption, business investment and overall economic activity — that the domestic economy will not be able to escape deflation’s gravitational pull.
Simple measures of distress
While we thought the economy was at risk of recession because of slower growth, the large external shock caused by the pandemic led to the bursting of the asset-price bubble in markets that then was the catalyst for the economy to grind to a halt.
The spillover from the global manufacturing slowdown and the effects of the U.S. trade war can be seen in the decline in real (inflation-adjusted) new manufacturing orders – as measured by the Conference Board – and the decline in a portion of the overall economy with an outsized impact of downstream businesses and life.
Fortunately for the U.S., the decline in the U.S. manufacturing sector was offset by the tightness of the labor market and robust consumer spending at the end of a long economic expansion.
Still, industrial production growth was negative, or nearly so, for each of the months since September 2019 (even before its crash in March), and the labor market and consumer sector began to tread water.
The RSM Monthly Index of Economic Activity — which has been in decline since the summer of 2018 — finally went negative in March as the coronavirus outbreak took over the narrative. Our index of underlying economic growth is now suggesting real GDP growth of less than 1% on average for the first three months of 2019, held up by still-strong consumer spending growth.
Yet given the shock in the labor market amid incomplete information, the data strongly infer a contraction in first-quarter growth in the area of 11.5%. That spending will be threatened for an indefinite amount of time now that 26 million newly out-of-work members of the labor force have been forced to show up at their state unemployment offices.
Unlike the shocks from the financial system created by dot.com bust of the early 2000s and the financial crisis that were transmitted to the real economy, the coronavirus health crisis has led to a swift shutdown of the real economy, with the shock then transmitted to the financial markets.
The financial markets have responded by:
- Recognizing the lack of revenue available for state and local governments.
- Degrading the prospects for potential growth.
- Pricing in the risk of a calamitous spiral of slow growth and deflation into long-term securities.
In the first instance, municipal bonds have traditionally been seen as a safe-haven investment, with tax-free returns implying lower interest rates. During the dot.com recession, the yield spread between munis and 10-year Treasury bonds fell and then popped up before resuming their normal pattern. During the financial crisis, the spread quickly grew to 125 basis points as investors questioned the ability of state and local governments to meet their obligations because of poorly conceived investment decisions.
Now, as out-of-work residents swarm unemployment offices, and with the prospect of reduced tax revenue from income and property taxes, the muni spread has widened out again toward 100 basis points, with investors seemingly withdrawing their money from mutual funds in favor of cash and the negative real (inflation-adjusted) return of money-market rates.
Those negative real returns don’t end with low money market rates, however. The yield curve is positively sloped once again, but only because the Fed has pushed money market rates to the zero bound. The real return (the nominal yield less the inflation rate) of longer-term maturity notes and bonds are negative all along the yield curve, from 2-year to 30-year bonds.
The figure below shows the change in the real yield curve since the fourth quarter of 2018, when the damage to the economy caused by the trade war had yet to be priced in by investors.
With respect to the setting of long-term nominal yields, investors in the fixed income markets implicitly require compensation for their expectations of short-term interest rates, and the risk that short-term rates might deviate from those expectations some time over the life of the bond. The latter is referred to as the “term premium.”
The yield on a 10-year Treasury bond is now a ridiculously low 0.56%, which is both an indication of expectations for economic growth over the next 10 years, and the risk that investors place on a catastrophic event (like the coronavirus shutdown) leading to a collapse of the economy.
As the drop in manufacturing suggests, even before the virus hit, we were at risk of turning a fully functioning economy into a Japan-like no-growth spiral, waiting for an aging population to begin limiting its consumption.
Before the trade war, interest rates were thankfully rising back toward the normal levels that would have supported an aging population. Instead of a 5% return on savings and a normal inflation rate, we have once again returned to 0.5% return on savings and the risk of deflation.
Nevertheless, North American crude production is a contributor to economic output, and the drop in commodity prices shown in the figures below, will have an impact on the value of energy and other resources produced in the U.S. and Canada and on the level of the respective GDPs.
While encouraging price supports for fossil fuels is hard to defend in a free-market economy, encouraging support for displaced workers with retraining programs and education would produce a virtuous cycle of increased productivity and potential GDP.
For more information on how the coronavirus is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.
