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Institut Montaigne hosted a webinar on May 7, in which Dr Janet Yellen, Chair of the Federal Reserve Board from 2014 to 2018, in conversation with Eric Chaney, Economic Advisor to Institut Montaigne, discussed economic observations during the crisis of Covid-19. The following article presents the key ideas of the webinar.
The sharp economic downturn in the US is simply without precedent. During the first quarter of the year, GDP shrank at a 4.8% annual rate, with every component of private spending contracting. With a potential decline of minus 30-40%, the second quarter will see a plunge in output larger than anything we’ve seen before, including the 2008 crisis. Most forecasters anticipate that the economy will revive in the second half of the year. However, it is likely that on a full year basis, the American GDP will experience a decline of a 7-10% range over 2019.
Beyond the decline in output, it is the impact on the labour market that has been particularly severe. Over 33 million people, over 20% of the labour force has applied for unemployment insurance and the unemployment rate is likely to exceed 20% as well. However, Congress passed a 650 billion-dollar grant program for small businesses, under the condition that these firms’ promise to keep their workers on payroll. Many unemployed workers therefore remain attached to their firms. That, in turn, means that if economic activity resumes reasonably quickly, many people will be able to go back to their jobs, making it easier for the firms to restart production.
Nonetheless, there will likely be a significant permanent job loss as a consequence of the structural change that is under way, which will likely last. The Congressional Budget Office now forecasts that the unemployment rate will stand at 8.7% at the end of 2021, and that many businesses will have to permanently close.
The crisis is having an impact on inflation, which is an important mandate of the Federal Reserve. The pandemic has led to a reduction in the supply of important goods and services, which would normally lead to an increase in prices. However, the overall negative effect of the crisis on demand has swamped the impact on supply. We are thus seeing a downward, instead of upward, pressure on inflation, paired with declining inflation expectations. The Fed and the ECB had been falling short of achieving their objectives for most of the last decades and the prospects are now looking grim.
There will likely be a significant permanent job loss as a consequence of the structural change that is under way.
An appropriate fiscal response is critical to support the economy through this period. Although the American social safety net is limited, congressional action so far has been substantial, more so than in 2008. However, more will need to be done if this period lasts beyond a couple months.
The strength of the recovery will depend in part on the damages sustained to the finances of households and firms in the coming months. American households were generally in good health before the crisis, but they will be taking on debt and decreasing spending for some time.
The intensification of the pandemic brought about a great deal of financial market turbulence. Investors fled from every risk asset to the safety of cash. The stock market plummeted, while the core markets, such as the treasury market, became illiquid. Private borrowing spreads above treasury increased dramatically, and short-term money markets froze up. In turn, investors fleeing from money market investments made it difficult for borrowers to obtain even short-term loans. On the bright side, the banks are stronger now than in 2008, with large capital and liquidity buffers. They have undergone stress tests that indicate they should be able to survive very substantial losses whilst still meeting the credit needs of the economy. However, they are likely going to be reluctant to lend in the face of such grave uncertainties.
The Federal Reserve has responded aggressively to the deteriorating situation. Their first objective has been to stabilize the financial system. With respect to monetary policy, the Fed quickly lowered its target for the federal funds rate to effectively zero on March 15. To put things into perspective, that is as low as that rate can go without the Fed moving to negative rates, something it is extremely reluctant to do. It seems that they intend to keep rates near zero until the economy is back on track and the inflation moving to its 2% objective.
The rates may stay near zero for years to come, which has pushed down the ten-year treasury rate to unprecedented lows. To ease liquidity strains in the markets for treasuries and mortgage-backed securities, the Fed started an open-ended asset purchase program in mid-March. They purchased approximately 1.7 trillion dollars of treasuries and mortgage-backed securities over six weeks. During the week of March 23, their buying pace was 100 billion dollars per day. That means that in one week they purchased about as many treasury securities as were associated with QE2, the second round of the quantitative easing program built to stimulate the US economy back in 2010.
The Fed does not control private lending rates, and though they have declined from the peak in mid-March, the spread of these rates over treasury rates remains considerably higher than pre-crisis. In other words, borrowing conditions for households and businesses are tighter, not easier. Therefore to further ease strains in credit markets and to ensure that credit remains available, the Fed has undertaken a large array of emergency credit programs. A major act called the CARES Act, passed by Congress in March, contains about 450 billion dollars worth of backing, permitting an enormous scaling-up of the Fed’s lending programs. The Fed could potentially expand these programs to roughly 4.5 trillion dollars.
The Fed is thus lending to businesses, large and small, to state and local governments, (something utterly unprecedented) and to purchases of asset-backed securities.
The Fed is thus lending to businesses, large and small, to state and local governments, (something utterly unprecedented) and to purchases of asset-backed securities. The terms that are on offer are better than what would be available now on the market, but if conditions improved, the terms would be viewed by most borrowers as penalty rates. That means that, as the economy recovers, these facilities will become unattractive, and borrowing should naturally scale back. These lending-programs are carrying out the Federal reserve's "lender of last resort" role.
As was the case in 2008, this has led to criticism over the Fed having become a handmaiden of fiscal policy, buying up the bonds that the government is issuing, creating money in the process which will ultimately become inflationary. But it should be kept in mind that in spite of large budget deficits and spiraling debt to GDP ratios, we will be dealing with inflation that is too low, not too high, for many years to come. Interest rates are likely to stay low, which will mean that the interest cost of all the debt being issued will not actually prove a severe burden on government finances. That has been true for many years in Japan, where the debt to GDP ratio actually escalated to 250%. That may be a huge concern for Japan and the world, but the burden of it has not been high. Importantly, the Fed has an ability to withstand political pressure from the fiscal authorities, hence the interest rates will reflect what is needed to keep inflation low and stable and the economy operating at its potential.
Eric Chaney
Janet Yellen
I am indeed concerned about financial stability. Good macroprudential regulation should encourage banks to build larger capital buffers when the economy is expanding, and then allow them to run down those buffers when times become difficult. The Fed is therefore appropriately allowing banks to run down capital and liquidity buffers now. Over the longer term, it will be necessary to insure that banks rebuild their buffers and not to permanently weaken financial regulations.
It is also important to remember that in the aftermath of the 2008 crisis, we did not focus enough on the non-banking financial sector, or the "shadow banking" sector. This crisis led to a meltdown in financial markets and short-term money markets came close to stop functioning, yet we had only limited reforms in the way money market funds work. We saw a financial system that did not react in a resilient way to the stresses, which makes for unfinished business in the current crisis, and reasons to worry about the stability of the financial system.
Eric Chaney
Janet Yellen
With the grim predictions of the Congressional Budget Office, and the potentially long time it will take for a vaccine to be widely available, the best case scenario for recovery would look like a U, instead of a V.
Much of what comes next for the US economy will depend on the public health situation, where we are yet to come up with a coherent national response.
Corporate America is not in good shape with respect to debt.
Keeping everything closed for so long is causing economic devastation. But if we open up before wide availability of testing, contact tracing, and a decline in the rate of infections we will be risking a W-shape scenario. In other words, we risk a second wave of infections, further overwhelming the American healthcare facilities and necessitating more lockdowns.
As for households, a Federal Reserve survey conducted about a year ago showed that 40% of Americans would not be able to come up with 400 dollars if faced with an emergency. That is a sobering statistic. However on a more positive note, the debt burden has also fallen significantly since the financial crisis, and the savings rate is substantially higher. Moreover, Congress provided support measures, such as making unemployment insurance more generous and easier to get. That shows that households are nonetheless in good shape overall for the time being, and if the crisis does not last too long.
What is truly worrying is that corporate America is not in good shape with respect to debt. In the non-financial corporate sector, leveraged lending rose enormously. Even with investment grade debt issuance, a very large fraction of it was at the lowest quality level, where it would likely be downgraded to junk in an economic downturn. And most of the debt that was issued was not for the sake of investment, but to pay dividends and to do stock buybacks. Some businesses, such as J. Crew, have already announced bankruptcy. I am concerned that these firms will cut back employment and spending to deal with their debt overhangs.
Eric Chaney
Janet Yellen
While Europe has more generous support for its workers, the toll on output will likely be as severe as in the US. Countries with a high level of debt, such as Italy, suffered a very severe shock. If those countries are forced to contract spending, the downturn will be yet more severe, bringing the European Union back to the usual issue: to what extent are countries in the EU willing to fiscally share the burden and move toward a more common fiscal policy, or at least directly support the most indebted countries?
The European Central Bank has to focus on the "transmission of monetary policy" throughout the euro area. That means worrying about blowing out spreads for more highly indebted economies. The ECB is indeed going to extreme measures to try to deal with a very difficult situation.
Eric Chaney
Financial markets have made a surprisingly fast recovery, in contrast with all other sectors.This may be partly explained by low interest rates, which are expected to stay so for a long time. We have not seen a 60-basis point ten-year treasury yield in modern American history. Low interest rates tend to boost what people are willing to pay for stocks.
Copyright : Apu GOMES / AFP
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