That the global COVID-19 outbreak has affected all aspects of daily life for everyone will be news to nobody. Some effects, such as social distancing, and facemasks, are evident just by looking. But other effects, such as those on monetary and fiscal policy, require more of an in-depth analysis—though these results will also affect us all.
Monetary policy is the management of money supply and interest-rate liquidity by the central bank, aimed at achieving macroeconomic objectives such as controlling inflation, consumption, and growth. These objectives are achieved by actions such as modifying the interest rate, buying or selling government bonds, regulating foreign exchange rates, and changing the amount of money banks are required to maintain as reserves. Monetary policy tools include open market operations (allowing the Federal Reserve to buy or sell U.S. Treasury bonds in such large quantities that it has an impact on the supply of money), direct lending to banks, bank reserve requirements (the minimum banks must hold against liabilities), unconventional emergency-lending programs, and managing market expectations.
Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation’s economy. It is the sister strategy to monetary policy. The objective of a fiscal policy stimulus package is to reinvigorate the economy and prevent or reverse a recession by boosting employment and spending.
Demand Shock and Supply Shock
Sometimes the economy is hit with a sudden drop in demand: a “demand shock.” A demand shock can be caused by a decrease in demand for exports, a downturn in consumer confidence, or a malfunction of financial markets. The result is a recession during which real output falls below its potential and unemployment rises. Inflation usually slows during a recession caused by a demand shock. Recessions caused by demand shocks can usually be remedied with timely use of monetary stimulus (lowering interest rates or other actions taken by the Fed) or fiscal stimulus (tax cuts or new government spending). The Great Recession of 2008-10 was largely the result of a massive shock to aggregate demand triggered by the contraction of lending and the collapse of housing prices.
In other cases, the economy may be hit by a “supply shock.” A classic example of a supply shock is the impact of an increase in world oil prices on an oil-importing country. Supply shocks can also cause recessions, but these recessions tend to be accompanied by a combination of rising unemployment and accelerating inflation.
Supply-shock recessions are harder to fix. If the Fed raises interest rates or the government cuts spending to fight inflation, that makes unemployment rise even more. If the Fed cuts rates or the government cuts taxes to mitigate the rise in unemployment, inflation will be worse. The best that can be achieved is a compromise between the two evils.
An even worse kind of supply shock not only causes prices to rise but puts quantitative limits on the amount of real output that can be produced. An embargo on the sale of vital inputs to a country, such as the Arab oil embargo that hit the United States in the 1970s or the sanctions imposed by the U.S. on Iran at present, are examples of such quantitative supply shocks.
The worst kind of recession happens when a country is simultaneously hit by both a quantitative supply shock and a demand shock. That is what we face with the COVID-19 outbreak. The supply-side effect comes from the disruption of international supply chains, aggravated by the fact that workers, either through illness or social distancing, can’t do their jobs. The demand-side effect comes from the fact that idled workers have less money to spend, and activities are curtailed by social distancing. (It’s important to note that social distancing is undertaken to limit a catastrophic shock to medical facilities—since there is no immunity or proven vaccine for the virus—which would have an equally devastating effect on the global economy and society.)
There is no way to completely overcome such a double shock in the short run. Fiscal or monetary stimulus can’t cure sick workers, can’t erase overcrowding of medical facilities, and can’t restore disruptions to international trade. The best that policy can do is limit the damage.
COVID-19 and Monetary Policy
During the crisis of the COVID-19 outbreak, central bankers have been the first out of the gates to attack the financial fallout. The first order of business was to increase liquidity in the financial system—leading to policy-rate cuts around the world and new quantitative easing programs for those central banks reaching the limits of lower interest rates. Around the world, both the Bank of England and the Bank of China cut the policy rate by 50 basis points and the Bank of Australia cut its policy rate by 25 basis points. In the U.S., the Fed first cut rates by 50 basis points on March 3, then by another 100 basis points on March 15, bringing the rate to 0.00-0.25. It has now pledged to buy unlimited amounts of U. S. Treasury and mortgage-backed securities, including commercial mortgages, starting with purchases of $75 billion and $50 billion per day, respectively. As of March 25, the Fed balance sheet sat at $5.2 trillion, a $1.5 trillion increase since September 2019, when the Fed began increasing its repo operations (taking in bonds from eligible banks in a de facto short-term loan of central-bank cash, collateralized by the bonds) to help calm the bank lending markets—which were already under some stress even before the virus hit. The Fed stands to almost double its balance sheet if all facilities are exhausted.
The second order of business was to act as lender of last resort—and, thereby, also improve liquidity—in an attempt to restore proper functioning in the credit markets. For the Fed, this meant dusting off many of the lending facilities created during the global financial crisis and adding a few new ones as well. These programs include:
- Commercial Paper Funding Facility, (announced March 17) through which the Fed purchases commercial paper (short-term unsecured promissory notes issued by companies) directly from firms.
- Primary Dealer Credit Facility, (operational March 20) through which the Fed supports primary dealers (24 selected trading counterparties of the Fed) in the purchase of a wide range of financial securities.
- Money Market Liquidity Facility, (a newly created program, though similar to a program used from 2008-10, operational March 23) through which the Fed provides liquidity to prime money market funds to ensure orderly operations.
- Term Asset-Backed Securities Loan Facility, (announced March 23) through which the Fed lends to support the issuance of asset-backed securities (credit card receivables, etc.).
- Primary Market Corporate Credit Facility, (a newly created program, operational March 23) through which the Fed purchases debt directly from companies.
- Secondary Market Corporate Credit Facility, (a newly created program, operational March 23) through which the Fed purchases corporate debt (and exchange-traded funds that invest in that debt) on the open market.
Taken together, these programs supports a wide array of financial lending—from ensuring companies have access to short-term lending through the commercial paper markets (vital for companies to meet day-to-day obligations) to ensuring money market funds maintain the necessary liquidity to meet client withdrawals (often corporations desperate to raise cash). The addition of the primary and secondary corporate credit facilities is noteworthy, representing an expansion of the Fed’s 2008 measures whereby the central bank is now able to purchase qualifying corporate debt, both in the markets and directly from companies. All of these programs are backstopped by the U.S. Treasury to the tune of $454 billion in aggregate and then levered up by the Fed to meet demand—potentially over $4 trillion, effectively doubling the Fed’s balance sheet. In total, this is a response that dwarfs the 2008 remedy both in size of asset purchases/lending and in scope. Clearly, the Fed is not messing around this time after learning the lessons of the 2008 financial crisis—the central bank means to be bold and go big.
COVID-19 and Fiscal Policy
The negative impact of COVID-19 on the economy and health of U.S. citizens forced Congress to work toward fiscal stimulus measures. The first measure, totaling $8.3 billion, passed into law on March 6. The bill focused on additional funding for the Centers for Disease Control and Prevention and other health organizations looking to inform and fight the spread of the virus. The law also looks to increase the availability of coronavirus tests and subsidize small businesses. On March 18, President Trump signed the second virus-related measure totaling about $100 billion. This measure provides improved sick and paid leave, better unemployment insurance benefits, additional funding for Medicaid and food programs, and free testing for the uninsured.
On March 27, Trump signed the Coronavirus Aid, Relief and Economic Security Act, or CARES Act. This relief package, totaling about $2.2 trillion, is the largest in U.S. history and is aimed not at trying to grow the economy but trying to prevent it from backsliding even further. The CARES Act is about trying to put a floor underneath people and make sure that businesses can stay afloat and not lay off as many people as they may have been forced to.
Congress expects these measures to go into effect in two to three weeks (as opposed to the two-to-three months it took during the 2008 global financial crisis).
Its components include:
- $500 billion in business lending. $454 billion will go to businesses, states, and municipalities. The remainder will go to passenger airlines, cargo air carriers, and companies related to national security.
- $376 billion will go to support small businesses with loan forgiveness and subsidies.
- $340 billion will go into an appropriations fund for hospitals and public health.
- $290 billion will go to directly help individuals, depending on income levels, facing loss of work.
- $250 billion will go toward unemployment insurance.
- $232 billion will go toward corporate tax relief.
- $150 billion will help replace lost tax revenue for state and local governments.
- $32 billion will go to payroll grants to employees of airlines, cargo companies, and contractors.
The fiscal policy response in the rest of the world has been quicker, but also smaller and more incremental. In Europe, fiscal measures to counter the economic fallout were rolled out relatively quickly at the national level. Australia has been more aggressive in its fiscal response, while Japan is currently debating a similarly sized package to that of the U.S.
Conclusion
The government already has chalked up $624.5 billion in red ink through just the first five months of the current fiscal year, which started in October 2019. That spending pace, extrapolated through the full fiscal year, would lead to a $1.5 trillion deficit, and that’s aside from any of the spending to combat COVID-19. Already, the national debt stands at more than $23.5 trillion and will be on track to eclipse $25 trillion again, aside from any COVID-19 spending.
During the financial crisis, the budget deficit as a share of GDP hit a high of 9.8%. Prior to that, the only period worse came during World War II when the level hit 26.9% in 1943. A $2 trillion deficit, which seems conservative given the current scenario, would push deficit as a share of GDP to 9.4%. A $3 trillion shortfall, which seems like not much of a stretch, would take the level to 14%.
While near-term setbacks are possible if not probable, we expect that as the health outlook improves, the market’s focus will shift to the combination of pent-up demand and significant policy stimulus. The virus poses significant near-term economic challenges; small businesses will suffer disproportionately; unemployment will rise meaningfully, and earnings will take a significant intermediate-term hit.
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