Policy Easing, but COVID-19 Uncertainties
Monetary policymakers face a dilemma. Interest-rate cuts have a questionable short-run impact in the face of a possible pandemic, but they are a tool that central banks can deploy quickly. The Fed will likely follow Tuesday’s 50-bp cut with further action, while select DMs and EMs will opt for modest interest rate cuts rather than large ones. Although early action on interest rates could mitigate panic in financial markets, it will not stop the spread of the virus, impact government-driven mitigation measures or curtail voluntary consumer restrictions on travel, eating out and entertainment. However, central banks can change monetary policy quicker than governments can change fiscal policy, and policymakers want to act quickly given the lags of monetary policy.
Other monetary tools are equally important. Central banks will likely announce additional liquidity measures, while some will also undertake macroprudential easing in the shape of countercyclical buffer reductions (e.g. the Bank of England) and possibly reserve requirements cuts, as well. One key uncertainty is the scale of direct help for weak companies in DM countries with the rollover of their debt and smoothing cash flow or tax payments. Italy has been proactive in delaying tax payments and follow-through from other G7 countries would be a positive sign, but there is a risk that DM policymakers will be too slow to act. EM countries are more likely to follow China’s example and relax lending constraints, delay tax payments, smooth cash flow and encourage debt rollover for weaker corporates.
Fiscal policy stimulation would be ideal, but it is likely to be more coincidental and moderate rather than coordinated and large. Coordinated fiscal action only followed the 2008 Lehman bankruptcy some five months later in March 2009 and the G20 is not as cohesive politically now as it was then. Even so, governments can enact public health education and prepare and scale up health resources quickly while only spending a relatively modest amount as a proportion of GDP. This can curtail anxiety among consumers and businesses. The U.S. government is also likely to make an infectious disease emergency declaration to free up FEMA funds. Governments could also take action to help fund treatment (such as with the remdesivir drug used to fight Ebola) or vaccine development. This can include direct funding and additional emergency powers for testing authorities to speed up the approval of a vaccine. However, most scientists still put a 12-18 month timeline on the large-scale deliverance of a vaccine and DM governments have not yet relaxed vaccine testing rules.
However, the damage to the Chinese economy from the lockdown in the Hubei province and extended holidays elsewhere appears to be larger than expected. China’s PMIs declined much more in February than they did in 2008 (Figure 2), while car sales are reportedly down 80% y/y. Additionally, existing local restrictions on migrant labor market movements are also slowing the rebound in production, while coal consumption is not rebounding quickly. An open debate is now occurring among economists on whether China is looking at a V-shaped recovery, a tick-shaped one or worse. The Chinese government will ensure that a rebound occurs, but the pace of such a rebound is now uncertain. Anecdotal evidence in Italy also suggests a sharp slowdown in tourism and volatility in big-ticket expenditure (e.g. car sales). Italy is also enacting more mitigation measures, which will adversely impact the economy.
Figure 2: China’s PMIs Tanked to Record Lows in the Face of the COVID-19 Outbreak
Source: Continuum Economics, Macrobond
The spread of the virus remains the most important factor. The good news is that COVID-19 can still be contained, according to a World Health Organization (WHO) statement from March 3, as it does not transmit as efficiently as influenza. With influenza, people who are infected but not yet sick are major drivers of transmission, which does not appear to be the case for COVID-19, according to WHO. The bad news is that clusters of outbreaks are growing in Europe and a material slowdown in the rate of change of new cases is not yet evident outside of China (Figure 1).
Additionally, fear of COVID-19 is already impacting consumer behavior where there have not been any major outbreaks, and panic-buying of essentials has occurred in many countries without major outbreaks. An Italian-sized outbreak in a U.S. city would promptly cause economically adverse measures (quarantine and some school closures) and significant stress among U.S. consumers. Such an outcome is probable rather than possible, even in our central scenario of containment.
This leaves financial markets volatile. Policy announcements will likely produce a positive response, but there would be an even better response from targeted health measures and other fiscal expenditure, rather than the blunt tool of interest-rate cuts alone. Moreover, it would be premature to say that the COVID-19 wave has peaked yet, given the problems surrounding transmission with mild symptoms. In retrospect, the Diamond Princess quarantine and the leap in Italian, Iranian and South Korean cases on February 24 showed the difficulties of containing COVID-19 before the reset of expectations. There is a risk that this volatility becomes intense and produces a further sharp selloff in equity and riskier corporate debt markets in the coming weeks. We could see the S&P500 at 2700 on by April.