JAKARTA (TheInsiderStories) – The spread of COVID-19 to the United States (US) is causing a sharp contraction in spending on activities that involve travel and congregating in public. Given the speed of these developments, we are taking the unusual step of updating our base forecast for the US between scheduled releases. We now expect a recession to begin in the second quarter.
With global growth slowing sharply, financial conditions tightening dramatically, energy prices plunging, and “social distancing” forcing cancellations of sporting events, Broadway shows, dinner reservations, travel plans, conventions, others, we now expect a sharp decline through June in “at-risk” personal consumption expenditures (PCE) on services to precipitate a consumer-led recession beginning in the second quarter and lasting through the end of the year.
The peak-to-trough decline in GDP is 2.3 percent, with the unemployment rate rising to 6 percent by mid-2021, and core PCE inflation slipping below the Federal Reserves (Fed)’ 2 percent objective.
This puts GDP growth for 2020, measured year-over-year, at -0.2 percent, and at +0.8 percent for 2021; the corresponding growth rates, measured 4th-quarter-to-4th-quarter, are -1.9 percent and +2.7 percent. A recovery, starting in the first quarter of 2021, will be impeded by lack of monetary policy space and an inadequate fiscal response.
We anticipate that GDP will contract at a 5.4 percent annualized rate in the second quarter. With slowing global growth undercutting export demand, additional wealth effects from plunging equity prices, a drop in domestic production of crude oil and energy exploration, and induced multiplier effects from all of the above, a -5 percent print for second-quarter GDP growth doesn’t feel like a stretch.
Even as consumer spending begins to recover during the summer, the legacy effects of the second-quarter contraction of PCE, continuing declines in energy exploration and production, and weak overseas growth will result in negative growth of US GDP averaging about -1.9 percent (annualized) over the second half of the year.
Fed Does Not Dither
While, on Sunday afternoon, the Fed announced aggressive policy responses to the crisis engulfing the United States stemming from the COVID-19 outbreak. The announcements were in response to economic forecasts that were marked down sharply and to further signs of potentially steep and longer-lasting disruptions.
The two most noteworthy elements of Sunday’ actions were an immediate cut in the federal funds rate to near zero (a target range of 0 percent to 0.25 percent) and announcement of a program that will result in the expansion of the Fed’ holdings of treasury securities and agency mortgage-backed securities over coming months by a total of approximately US$700 billion.
What Comes Next
Sunday’ aggressive rate cut could be the “final” adjustment to the fed funds rate, as there is little appetite now within the Federal Reserve for employing negative interest rates.
To be sure, if our economic forecast that includes a severe but brief recession is accurate, inflation is more likely to remain below 2 percent for several years and the unemployment rate will rise by approximately 3 percentage points and remain above its full employment level.
In such conditions, the federal funds rate would be likely to remain near zero for several years. Relatedly, the FOMC appears poised to announce within the next few months the results of its review of monetary policy and strategy.
We anticipate that it will announce an adjustment to the inflation-targeting portion of its framework to incorporate elements of flexible average inflation targeting that would permit the Fed to announce that it would accept, or even promote, a moderate overshoot of 2 percent inflation as a tool to buttress long-run inflation expectations and possibly boost nominal interest rates. If credible, such a framework could result in more capacity to provide stimulus by lowering real interest rates.
While the Chairman refused to describe the asset purchase program as quantitative easing, that could change if the economic fall-out looks to persist beyond just one or two quarters. A longer-lasting downturn would likely result in the announcement of expanded asset purchases beyond those announced on Sunday, as a tool to further lower bond yields and mortgage spreads.
Finally, the Fed, with recent actions, signaled that it is prepared to move decisively and aggressively to mitigate negative economic impacts and create conditions that will help promote an eventual recovery, and that substantial fiscal and other policy interventions to help contain the spread of the disease and its economic repercussions are called for as soon as possible.
by Joel Prakken and Ken Matheny, Chied and Senior Economist at IHS Markit