As Virus Impact Deepens, Three Things to Watch

A review of recent developments and their implications for the U.S. economy and U.S. Federal Reserve policy.

1. U.S. GDP Data Offer Few Surprises, But One Significant Clue

The first-quarter report on U.S. gross domestic product (GDP) played out pretty much as expected—GDP dropped 4.8% from the previous quarter as restrictions aimed at checking the spread of Covid-19 took their toll on the economy. A very sharp drop in consumer spending, led by services, was the primary cause.

While the first-quarter release is obviously a glance in the rear-view mirror—GDP appears poised to decline at a double-digit pace in the second quarter as the lockdown measures weigh on the labor market and overall activity—we believe one other facet of the report is worth emphasizing. Residential construction was very strong going into the downturn, as evidenced by the component reading in the GDP report. We believe it has the potential to be comparably strong on the other side. It also seems to be one of the first industries poised to re-open when states ease quarantine restrictions.

2.  The Fed’s Efforts to Bolster Liquidity Appear Successful

Recent emergency balance sheet expansion by the U.S. Federal Reserve (Fed) has been aimed at ensuring that short-term funding markets continue to function.

The Fed’s Balance Sheet: “Expansion” Is an Understatement
U.S. Federal Reserve Bank assets, July 2, 2008-April 29, 2020

Source: U.S. Federal Reserve Bank of St. Louis.

And the Fed has been successful. An increasing spread based on a measure of interest on excess reserves from the U.S. Federal Reserve Bank of St. Louis (St. Louis Fed) implies that reserves are being supplied generously again, and remain ample despite the fact that an increasing amount of liquidity has been absorbed by the U.S. Treasury. Meanwhile, the emergence of a positive basis in U.S. dollar denominated foreign exchange swaps shows that expansion of repo facilities with foreign central banks and other official institutions has been enough to satisfy demand for dollars outside the United States.

So far, we think the Fed should get very good marks for its performance as crisis manager. But the central bank has another task at hand: It must transition to doing its utmost to implement stimulative monetary and credit policies that will foster as rapid an economic recovery as possible.

3.  Falling Inflation Puts Onus on Fed to Boost Stimulus

That task takes on added relevance following the release of new inflation data on April 30. Falling core prices (which exclude food and energy) in March, as measured by the Core Personal Consumption Expenditure Price Index (PCE Index) deflator, lowered this inflation measure to 1.7%, year-over-year, farther below the Fed’s 2% target. Inflation expectations have fallen even more, based on data from the St. Louis Fed.

Aggressive monetary policy, even at the risk of inflation eventually rising above the 2% target, is especially important, as Fed Chairman Jerome Powell emphasized at the press conference following the conclusion of the Fed’s April 28-29 policy meeting, because the labor market had tightened enough before the Covid-19 shock to have begun generating a broad-based increase in wages and salaries that were starting to benefit the lower paid and less skilled workers who had been bypassed in the early stages of the economic expansion. These are precisely the people who tend to lose the most ground when the economy slides into recession.

In our view, that vulnerability increases the urgency for the Fed to implement a sufficiently stimulative monetary policy to have a large impact at the effective lower bound for interest rates (the Fed’s current target for the benchmark fed funds rate is 0%-0.25%). We believe the Fed still has sufficient “dry powder” to provide further stimulus as the effect of the virus-led disruptions on the economy deepens in the coming weeks and months.