Looking Beyond The Pandemic To The Future For Economic Growth

Although we have yet to come through the worst of COVID-19, economists are starting to look are the major implications for a post-pandemic world. Will there be a rapid V-shaped recovery and a return to customary growth with minimal damage? What will unemployment, inflation and interest rates look like one, two and five years out? And, what are the longer-term consequences of the battle against the coronavirus?Two papers published by the Federal Reserve delve into these issues and their conclusions are quite sobering.

First, lets look at the short run consequences. The Fed researchers examined the evidence from the past that ‘triggered outsized and sudden changes in the fear index”, or the VIX. Their conclusion is unambiguous:

“Evidence suggests a clear pattern in which periods of heightened uncertainty are followed by persistent increases in the unemployment rate and protracted declines in inflation, despite declines in interest rates…... We estimate that a surge in uncertainty to a level similar to the recent spikes in the VIX would have significant negative impacts on the macroeconomy. It would lead to a persistent increase in the unemployment rate of roughly 1 percentage point, while simultaneously reducing the inflation rate by as much as 2 percentage and bringing the interest rate close to its zero-lower bound “

More importantly, the paper asserts that:

“However, these estimates will surely understate the overall impact of the current pandemic in the near term because they do not account for other negative impacts through, for example, supply chain disruptions, labor shortages, and widespread shelter-in-place measures. “ This latter point cannot be over-emphasized.

The uncertainty manifests itself in the labor market. Employers will be very careful about hiring, awaiting firm proof that their sales and markets have returned. Elevated uncertainty reduces consumer spending as households opt for increased savings as a precautionary measure. Hence, overall demand will be very much muted as we come out of self-isolation and businesses re-open. Slow employment growth removes any prospect for igniting inflation.

Second, the longer term. The other Fed paper studies the return on assets using data stretching back five centuries from 15 major pandemic episodes where more than 100,000 people died. The study focuses on the response of the real rate of interest to a pandemic shock. That is, the level of real rates of return on safe assets, such as sovereign bonds, in a world of stable prices. Again, the Fed researchers’ conclusions should dampen expectations of a return to robust growth--- the myth of the resilience of the consumer we hear about so often.

“Following a pandemic, the natural rate of interest declines for decades thereafter, reaching its nadir about 20 years later, with the natural rate about 150 bps lower had the pandemic not taken place…. It is well known that after major recessions caused by financial crises, history shows that real safe rates can be depressed for 5 to 10 years…”

On more positive note, though, the study suggests with low interest rates available for decades on, governments will have considerable fiscal room to finance deficits as a result of their efforts to re-start economic growth. 

Summing up, investors are going to hear a lot about the shape of the economy recovery, post-pandemic. Wall Street will need to keep its clients invested in equities on the expectation that “this too will pass” and the market will rebound successfully - the V-shape recovery. The research provided by the Fed staff economists does not lend support to this view in the either the short or long-term. The trauma from COVID-19 will be both deeper and longer than any we have experienced in the modern era.