As coronavirus outbreaks have become more threatening outside China in recent days, attention has turned to the likely damage to global output and to the possible reaction of macroeconomic policymakers. This has become urgent with the catastrophic decline in China’s PMI business surveys yesterday. The question now is whether a global recession can be avoided.
While the health risks from the virus seem lower than seasonal influenza, the response of the public health authorities has been fairly draconian in many affected regions, causing large drops in industrial and consumer activity.
Until Friday, the official response of macro policymakers in the advanced economies (AEs) to these events had been rather complacent. Leading Federal Reserve officials had said that they were monitoring the extent of the global economic shock and that they had scope to act, but they saw no urgency to cut interest rates. The European Central Bank and Bank of England have reacted similarly.
Fortunately, this language suddenly changed with Fed chairman Jay Powell’s brief but pointed statement late last week, effectively paving the way for an early reduction in US policy rates. The forward markets, which have reacted more quickly than the Fed on this occasion, are now expecting policy rates to decline by almost 1 percentage point in the next 12 months.
The likely path for rates now seems fully priced in, on central assumptions about the extent of the output damage, and the type of economic shock that develops.
Before last week, consensus forecasts showed that activity in the advanced economies would be affected meaningfully in the first half of 2020, but that most of the lost output would be regained in a V-shaped recovery in the rest of the year. Global gross domestic product forecasts for the 2020 calendar year had dropped by only 0.2 per cent.
However, there has been a significant darkening in opinion in the last few days. Many forecasters are now talking about a more dire scenario, involving nothing better than a U-shaped cyclical pattern. Further downward revisions to consensus GDP projections for the 2020 calendar year of at least half a percentage point seem highly likely.
There has been some debate about whether the coronavirus shock should be classified as a demand shock, a supply shock or a financial shock. It seems to have some features of all of these, though confidence effects and tightening financial conditions imply that demand effects are now becoming dominant.
Economists like Olivier Blanchard, who emphasise the supply side effects from a falling labour force and disrupted supply chains for goods are right in principle, but that will not stop the Fed from easing. There is no danger of supply-induced inflation in present circumstances.
In China, the initial effects of enforced industrial shutdowns that have affected global value chains may soon ease.
The politburo decided recently to permit the reopening of some industrial plants. While President Xi Jinping’s attitude still seems very confusing, there is early evidence from JPMorgan’s daily tracking data that the flow of international trade through the nation’s ports and airports has rebounded towards more normal levels. March could be a difficult month for global manufacturing output in many economies, but supply chains may improve in the spring.
The problem is that mitigation measures designed to slow the spread of the virus are likely to lead to severe declines in consumer confidence and lower levels of expenditure on services such as travel, restaurants and hotels in population centres.
Small companies in consumer service sectors, without easy access to bank finance, have rapidly faced liquidity problems which are threatening to cause a credit crunch in China.
Interest rates have been reduced throughout Asia and, more importantly, central banks have provided extraordinary credit facilities to encourage commercial banks to maintain funding to stressed companies. More of these emergency policy interventions may be needed in the major economies very soon.
In summary, the lesson from the virus-hit economies is that a large demand shock will probably develop in the advanced economies, affecting consumer spending, with a financial squeeze threatening SMEs. This is likely to lead to a weakening labour market and lower inflation. There has also been a supply chain shock, but this may soon start to abate.
Should markets be worried that policymakers cannot now prevent a global recession?
In a plausible downside scenario, Fed Board member Lael Brainard’s recent speech on monetary policy in a collapsing US economy would become highly relevant. She recommended that US policy rates should be reduced to zero, with forward guidance promising to hold rates at zero until inflation had returned to the 2 per cent target.
This would be backed by Japanese-style yield curve control. Yields on medium dated government debt would be capped, and the central bank would buy 10-year debt outright. This should be supported by a fiscal easing, while bond yields are held close to zero.
Ms Brainard is a dove, but her speech might become the Fed’s road map for the downside case, in which a Covid-19 global recession is threatened.
The news about economic activity in the advanced economies will certainly get worse before it gets better but there is still time for determined policy action to avert a recession.
Alberto D’Onofrio and Juan Antolin-Diaz have provisionally updated Fulcrum’s nowcast models for Chinese activity in the wake of the alarming February PMI data released yesterday. Because the data are probably affected by very exceptional, temporary hits to sentiment, they have assumed that two-thirds of the February drop in the PMIs is reversed next month, and after that they have allowed the model to work as normal.
The model’s latest estimate for current activity growth has dropped to 2.3 per cent from 7.0 per cent last month.
The forecast shows a moderate recovery in GDP growth from the second quarter onwards, with growth in the calendar year falling to only 4.6 per cent, the lowest in recent decades. Policy interventions might speed up this recovery somewhat.
Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 1 March 2020.
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