With the onset of the COVID-19 pandemic came depression-like declines in output and employment. The U.S. government reacted quickly and boldly with unprecedented fiscal and monetary stimulus. Now, as we look at the depth of the recession and the government’s response, we consider how the recovery will play out.
That leads to two important questions that we’ll address. First, is the economy like a light switch, turned off to fight the pandemic, then turned on afterwards, with the light as bright as before? Or, will this recession, like the three that preceded it, have a long recovery stretching far into the future? Second, will the rush to implement extraordinary fiscal and monetary policy lead to unintended consequences, or does the depth of the recession make these policies benign? The first question has to do with changes in the nature of economic behavior on the part of individuals, households and firms and the second with the current debate over deficits and inflation.
Depth of the Recession
The current contraction in economic activity is the most rapid and deepest since the Great Depression. It’s also the first recession in our lifetimes caused by a public health crisis. The course of this crisis over the next few years is crucial to the depth and duration of the recession. Even though infections continue to increase to record levels, the worst of the crash is likely over. For the U.S. economy, we’re estimating that when the final gross domestic product (GDP) numbers are released for the second quarter of 2020, they’ll show a decline of 9.5% from the previous quarter (not annualized), followed by a moderate recovery that won’t return the level of output to its fourth quarter 2019 peak until 2023 (see “Economy Predictions (GDP),” this page). On a fourth quarter to fourth quarter basis, we forecast that real GDP will decline by 8.6% in 2020.
The decline in output has resulted in record levels of unemployment. April’s unemployment rate hit 14.7%, up from 3.5% in February (see “Unemployment Rate,” p. 43). With the easing of business closures, the unemployment rate declined to 10.2% in July.1
The federal government and the Federal Reserve have responded quickly to this crisis. To date, the federal government has provided approximately $2.7 trillion of COVID-related federal aid (equivalent to 12.6% of GDP), with more stimulus expected to come. The Federal Reserve moved to zero interest rates, accelerated government bond purchases, committed to supporting the corporate bond market for the first time in history and launched several new lending programs. As a result, its balance sheet has grown by $2.9 trillion (equivalent to 13.5% of GDP), from $4.1 trillion in late-February to $7 trillion in early July.2
Climbing Out of the Recession
The economic recovery depends on people feeling safe, which depends on containing the spread of the virus. Even before local governments issued stay-at-home orders, high frequency data showed that individuals largely stopped eating at restaurants, stopped traveling and stayed home (see “Table for Two?” p. 44). Evidence from the recent spikes in cases in several states confirms that many people will react by cutting back on activities they consider high risk, even if there are no mandated shutdowns.
Simply put, it will take time for consumption to return to normal, and for some sectors, it may never happen. After 9/11, for example, it took more than two years for air travel to return to its prior peak. The pandemic is a similar situation in that safety is a paramount concern. There will be those who return to old habits relatively quickly as we’ve seen in some of the states that opened up in May, and there will be others that respond much more slowly. Older individuals, who typically have more income to spend, will also be, on average, more reticent to go to restaurants, bars and attractions.
The pandemic has also accelerated structural shifts. Though a return to the office will be coming, it will take time and might be very different. Brick-and-mortar retail was already in trouble in the last expansion and it’s now imploded. While software and sanitation will benefit from the new work and social environments, support and personal services will need staying power to survive this downturn. Thus, from the deep recession through the first years of the ensuing expansion outlined here, we should expect considerable idleness of labor, capital and land.
The fiscal stimulus, including payments to households and expanded unemployment insurance, likely created a 7% increase in personal income in the second quarter of 2020, even while economic activity declined. This increase led to higher savings and not to increased spending. A limited reopening in May and early June resulted in a partial rebound in retail purchases, but significant additional increases through the summer and into autumn are in doubt. The evidence from past deep recessions also suggests that households and businesses will try to repair their balance sheets and increase their financial reserves. That is, they’ll save more and spend a lower share of their income than they did before the pandemic.
With decreased spending, the switch might be thrown, but the light will be considerably dimmer. Because of weak consumer demand, inflation is likely to remain below the Federal Reserve’s 2% inflation target at least through the end of 2022. We forecast that GDP will increase by 5.3% and 4.9% in 2021 and 2022, respectively. Our forecast horizon is the beginning of 2023, and we don’t foresee the economy returning to its long-run trend by then. As the pandemic is still very much with us, unemployment will likely remain near double-digits through the end of the year (see “Unemployment Rate,” p. 43). Even with our assumption of the pandemic abating by next year, we expect the unemployment rate to exceed 6% at the end of 2022. If cases continue to rise and parts of the economy shut down again, households will be unable or unwilling to increase spending, and the recovery will be even weaker.
Deficits, Money and Inflation
As the recovery gains momentum in the middle of the decade, the risk of accelerating inflation will increase. There are two reasons for this increased risk. First, fiscal stimulus and monetary policy have injected massive amounts of liquidity into the economy. This liquidity will boost demand as consumers feel more confident about going out and spending. Second, the pandemic is causing businesses to prioritize resiliency over efficiency. Their increased costs will translate into higher prices. How important is this? There are three views in the economics profession that help explain inflation risk. They can be roughly characterized as Monetarist, Keynesian and Modern Monetary Theory (MMT).
In the current environment, the Monetarist and Keynesian views aren’t far from one another. For both, inflation is a consequence of the supply of money and the rate at which it turns over in the economy. Right now, the Federal Reserve’s actions have dramatically increased the supply of money, but firms and consumers are hoarding cash. As confidence returns and consumers spend more money into the economy, the turnover rate will increase. There’s currently a lot of slack in the economy. But, as the economy begins to recover and it becomes more difficult to shift resources into sectors that are growing, the increase in demand allows some firms to raise prices and creates the conditions for an inflationary cycle to begin. The Monetarist view is that the ability to mitigate this risk through discretionary policy is limited. In the Keynesian view, the Federal Reserve can adjust the supply of money during the expansion to mitigate inflation risk. For both, idle resources at home and abroad can absorb the increase in demand without inflation in the near term.
MMT offers a less orthodox view of deficits, money and inflation. As long as inflation is low, MMT argues that the federal government can run deficits and finance them by having the Federal Reserve create more money. This doesn’t differ from the more orthodox view of the risk today. However, MMT also advocates for a long-term extension of the current fiscal and monetary stimulus. This is based on the belief that today’s world is an employment-poor place, and it will be for the foreseeable future. Even when the expansion is in full force, automation, artificial intelligence, robotics and other new technologies will eliminate the need for a significant part of the workforce, resulting in slack resources. With slack resources, deficit spending won’t be inflationary. Instead, according to MMT, it will lead to higher tax revenues and, in a sense, pay for itself.
What’s the empirical evidence for these views? Certainly, the coexistence of Monetarist and Keynesian views over the past 70 years demonstrates that there’s some empirical evidence to support both. The management of money and deficits in the United States during this period has, with the exception of the late 1970s and early 1980s, resulted in very little price inflation. As of yet, there doesn’t exist a large body of empirical evidence to support MMT’s view of long-term slack in labor markets. Though U.S. monetary policy beginning in 2008 is suggestive, an analysis of MMT policies across countries doesn’t provide much support. What’s required for MMT is a faith in monetary policy such that the turnover rate of money remains low. Present day and historical examples, from Venezuela, Argentina, Brazil, Zimbabwe and Weimar Germany, tell us that large-scale inflation can ensue despite idle resources and high unemployment if faith in monetary policy is lost. If the MMT advocates are correct, and MMT policy were to be implemented, then inflation risk might be low; however, current evidence indicates that this policy carries considerable inflationary risk.
The economic recovery has begun, but it’s tenuous and uncertain. The trajectory will depend on the course of the pandemic and the policy responses to it. But, it most certainly won’t be a snap-back V, as the light switch analogy suggests, and fundamental structural changes are underway. While there’s a great deal of uncertainty about the economy at this time, there’s general agreement that the next three years will be a period of low inflation. Therefore, room still exists for non-inflationary fiscal and monetary easing, and the inflation question is whether or not mid-decade government policy will rein in inflationary forces.
Endnotes
1. U.S. Bureau of Labor Statistics. Seewww.bls.gov/charts/employment-situation/civilian-unemployment-rate.htm.
2. Federal Reserve Board of Governors. Seewww.federalreserve.gov/monetarypolicy/bst_recenttrends.htm.