Economic Contagion: A Targeted, Timely and Transparent Policy Response
06 March 2020 by Gerard Lyons
The predicament we face now is unlike 2008, which was a Global Financial Crisis (GFC). This is a Global Health Crisis. Then the focus was on addressing financial issues. Now the focus is about addressing health issues.
One similarity to 2008 is that there will be a significant economic fallout. The outcome in 2009 was a deep global recession but policy prevented something far worse, a depression. Now there is likely to be a significant but temporary slowdown, possibly lasting half a year, but because of the uncertain nature of this virus there is a danger the downturn could last longer.
Although governments across the globe provided a fiscal stimulus at the 2009 G20 London Summit, in the aftermath of the GFC the main focus of the policy response was on monetary policy. It acted as the economic shock absorber, so much so that now, over a decade later, rates are low and central bank balance sheets are bloated and there is not as much monetary ammunition left to deal with new shocks, such as this virus.
Central banks likely to do more
Yet as we have seen over the last week, central banks remain in the front line of the policy response. The US Federal Reserve (the Fed) cut by 0.5%, resulting in an upper bound for the Fed funds rate of 1.25%. Further Fed easing is inevitable as inflation is not a concern and given the economic uncertainty and risks – a cut to 1% is likely and potentially lower the longer the crisis lasts. In fact, 32 central banks have already cut rates this year. More are likely to do so, including the Bank of England.
While monetary policy still has an important role to play as the crisis unfolds, there needs to be a ‘Whole of Government’ approach involving fiscal, monetary and prudential policy. Fiscal policy easing is already underway globally, spearheaded by emerging economies. While helpful now, it will compound an existing challenge, namely over the high level of global debt.
This whole of government approach is needed in the UK and needs to be: Targeted, Timely and Transparent.
Targeted at areas needing immediate help. A significant aspect of this crisis is that it impacts the supply side of the economy, as it hits supply chains, exposing small firms who rely on cash flow to survive. But like previous such shocks it impacts the demand side, too, as trade slows and discretionary spending weakens. Demand and supply side policy responses are needed.
In addition, specific sectors may be more exposed, such as point-to-point travel by Uber or taxis, retail spending and tourism. Targeted measures must also focus on those whose cash flow would be impacted if they are forced to self-quarantine for two weeks and who may be laid off from work as demand slows. Last week, for example, the Budgets in Singapore and Hong Kong responded with targeted measures for these groups, including cash handouts for those on low incomes.
Timely, in the sense of when to implement policy stimulus and for how long. The UK is fortunate that the Budget is imminent as this will allow immediate support to be provided. Also, on the monetary side it makes sense for pre-emptive measures, outlined below, and for them to remain in place until the economy has turned the corner for the better.
Transparent, with policy measures being clear and well communicated. The lesson from previous shocks of this type is that, while they are not all identical, the impact on the economy can be thought of as being V-shaped or U-shaped. The maximum economic impact is in the first two quarters after the initial shock and then there is recovery, often helped by policy, although sometimes policy may only feed through after the economy has turned the corner.
China’s economy was at a standstill in January and February. Although the official message there is that it is over the worst, it is clear the economy will take time to recover. Last week there were suggestions the economy was back to 60-70% strength and the high frequency economic data is still weak. Our expectation is of a return to normal there in Q2.
A challenge is that the contagion has been evident already and other countries will likely experience similar temporary hits as China did. Japan (especially with its elderly population) may grind to a standstill, too. South Korea is unveiling major economic policy measures. Supply chains globally will be impacted for some time even if China recovers soon, especially if the US is impacted, as seems likely, as we move into Q2.
The UK approach
This week the UK Government outlined its approach to the crisis. In all likelihood there will be a surge in cases, and only time will tell whether enough has been done to contain the virus.
The official message stated, “Once the virus becomes impossible to contain, it will take six to eight weeks to reach its peak, with the peak period lasting four weeks, perhaps at different times in different parts of the country, before a decline lasting up to 12 weeks.”
This would point to the virus hitting the UK economy hard in Q2, in all likelihood bringing it to the type of temporary standstill seen recently in China. This prospect would justify significant fiscal measures in the imminent Budget as well as action by the Bank of England (BOE).
The BOE should have a bias to ease. Previously the market consensus was that a large fiscal stimulus in the Budget would remove the scope for rate cuts. Now, however, fiscal and monetary easing is justified. I would expect policy rates to be cut from 0.75%. An immediate cut to 0.5% seems likely at the March meeting, and I would favour a reduction to 0.25% in Q2 but the Bank will likely wait to see how the data unfolds, perhaps with a focus on other measures.
To ease supply side pressures the Bank is likely to add liquidity and could consider lending schemes or loan guarantees for small firms.
Other measures could also include easing prudential measures such as capital requirements on banks or measures that limit people’s ability to borrow. They could work with banks to ease forbearance or credit conditions for those facing cash flow problems.
The policy measures taken will be driven by the path the virus takes and by the economic data.
Challenges are hard to quantify
No one should be complacent, especially as cases will rise and deaths occur. There are no economic silver linings to this crisis, although there will be lessons learned.
If one is looking for positives: the virus appears to have peaked in China; the sequence of the virus was detected quickly and a vaccine is expected to be available in a year; over 82% who catch it will not be impacted too much; a drug may be used on the seriously impacted (Remdesivir). Plus, in the UK, people here are not panicking (yet) and so will likely self-quarantine and that may mitigate its spread.
The UK challenge is the scale of the population (the old and vulnerable) who may be impacted seriously if the coronavirus is not contained – the government this week said in this case 80% would be affected, which is effectively assuming most people will be exposed to it but some will be immune. If so, the numbers impacted here will have a wider contagion impact (on services and public mood). The economy will likely follow the path of China and grind to a temporary halt.
This week the IMF repeated its view that world growth would be severely impacted; it now expects growth to be less than last year. That should not be a surprise as, at the start of the year, China and the rest of Asia were expected to account for around two-thirds of global growth this year. The OECD this week, reflecting the shift in economic thinking, cut its measure of global growth this year from 2.9% to 2.5% but stated that a longer-lasting and more intensive outbreak could reduce this to 1.5%.
While the focus here is on the immediate, there will be longer-term consequences. Following the 2008 crisis regulation focused on faults in global banking. Now it should be about strengthening the global health response while also posing a challenge to economic globalisation and a likely preference for localism over just-in-time global supply chains.
Even ahead of this crisis, one of the issues for the market was where we are in the economic cycle – the issue being whether we were near the end of the cycle and if so, was there enough policy room to respond? Now, it seems inevitable that this crisis will result in rates being lower, liquidity more abundant and debt levels even higher.
Safe havens continue to perform well. Yields will stay low. Equity markets, whilst currently volatile will potentially offer good value if we are right that economies will rebound later this year.
Please remember that when investing your capital is at risk.