It is natural to want to rush to judgement about the long-term changes the coronavirus pandemic will bring, whether in an attempt to get ahead of the game or simply impose some order amidst the chaos. But as understandable as that impulse is, it can also be dangerous, allowing highly speculative claims to circulate and gain currency – almost like the virus itself.
Take the common assertion that this will finally be the crisis that gives way to an era of much higher inflation. The narrative is deceptively simple. To prevent a deep recession from turning into a depression, governments are racking up deficits rarely seen outside of war time. Because growing our way out of the resultant debt overhang will be impossible, inflating away its real value, aided and abetted by central bank asset purchase programmes, is the only viable escape route.
But think more deeply and the narrative starts to unravel. Similar claims were made immediately after the global financial crisis (GFC) when public debt ratios jumped across a wide range of countries and central banks first began buying government bonds in size.
In reality that crisis opened up enormous amounts of spare capacity in the global economy. That, together with persistently sluggish demand, as well as other structural forces, ultimately put significant downward pressure on labour costs and margins over many years. The upshot is that in most countries, inflation was still below central bank targets more than ten years after the GFC ended (see Chart 1 below).
Chart 1: The GFC was a disinflationary event
* dark line represents realised path of the advanced economy core consumer price index.
** dashed line represents what the path would have looked like if the pre-GFC trend had been maintained
Source: Haver, ASIRI (as of 2020)
The claims also don’t align well with what central banks are actually doing. The objective of quantitative easing isn’t to finance budget deficits; it is to loosen financial conditions when policy rates can’t go any lower.
In fact, deploying quantitative instruments has always been the bread and butter of central banks. Before the GFC, open market operations were used to keep overnight rates close to their target. And it was not so long ago that central banks primarily achieved their objectives by varying the growth rate of the money supply.
QE then is just the natural extension of those actions into a wider set of long-term bond and credit instruments. Could this eventually give way to an era in which central banks lose their independence and become subservient to government financing needs? Yes, which almost certainly would be inflationary. But is it more likely than the current crisis proving to be as disinflationary as the post GFC did? Absolutely not. Investors should be at least as worried about the world becoming more like Japan as returning to the inflation of the 1970s.
Just as some commentators have been too hasty to write the story of future inflation, so it is for the future of economic growth. Some effects seem obvious – like the acceleration of on-lining and more resources being directed towards health systems - but most are not. The list of questions one has to get right to accurately forecast the path of GDP over the next decade is therefore dauntingly long.
To illustrate the point, consider the following four questions. These are difficult to answer with much confidence, but will heavily shape the future of growth:
- Will future outbreaks of Covid-19 be severe and widespread, or moderate and geographically isolated?
- Will the current crisis strengthen or weaken countries’ willingness to work together to overcome common challenges?
- Will domestic fiscal support measures be kept in place for as long as private demand is constrained, or withdrawn quickly as was the case after the GFC?
- Will the regulatory and policy responses to the crisis increase or lower incentives for firms to innovate and be rewarded for that innovation?
Arrange those four questions in a decision tree and one is left with sixteen different long-term trajectories for the global economy that will in turn also influence the path for inflation, earnings, interest rates and the path of risk assets. And this is by no means an exhaustive list of the important questions that need to be answered.
With such a bewildering number of plausible alternative paths to consider it is easy to give up on formulating views about the future altogether. However, there are some things we can do to guide our decision making while also ensuring that as we look forward, we do so with humility.
One is to develop rigorous analytical and research frameworks to answer the most important questions, while ensuring our views are founded on the strongest available evidence. Across the firm we have a number of collaborative projects on the go that are focused on doing just that. The second is to be honest about the uncertainties and articulate the wide range of plausible alternative scenarios to our central views.
Table 1 and Chart 2 are examples of this second approach in action. Here we have identified five paths for the global economy over the next three years, each of which is anchored on a different set of assumptions about the course of the virus, attendant containment measures, the efficacy of policy responses and the extent to which the crisis permanently scars behaviour and activity. We have assigned indicative probability ranges to each outcome and think they bound the range of plausible aggregate outcomes.
Table 1: Coronavirus recovery scenarios
* Indicative probabilities are estimates with wide confidence intervals and should be interpreted with caution given the high levels of uncertainty regarding virus progression, policy steps and behavioural responses. The scenarios in the table account for 75% of total probability mass; the remaining 25% sits in the vast range of alternative potential outcomes that cannot be captured in this exercise. Importantly, missing scenarios are not necessarily to the upside: the numerous alternative possible outcomes are likely a spectrum of downside as well as upside scenarios (relative to the base case).
Source: ASIRI (as of April 2020)
In our base case a very deep recession is followed by a solid recovery from the second half of the year as containment measures are gradually scaled back and policy support can have more effect. However, that recovery is expected to be more gradual than the initial correction and we are factoring in a permanent loss of output equivalent to roughly a full year of trend global GDP growth.
Considering the risks to that outlook, we think a weaker recovery and larger permanent output losses are more likely than a rapid recovery and no permanent loss. That is primarily because we think the risks are tilted toward containment measures being phased out more slowly, which in turn induces larger and more persistent changes in private sector behaviour. It is also hard not to see at least some policy mistakes being made along the way. Indeed, there is a good chance that our next set of official forecasts will incorporate more of these downside risks into our central view.
Nevertheless, like any good Bayesian, we are prepared to update these views frequently when compelling new information about the key waymarks and triggers for each scenario comes to light, or we consider things to have changed so much as to require new scenarios altogether. That includes being prepared to revise our forecasts up in the face of durable, positive surprises to the key drivers.
We can’t promise we will get everything right. But drawing on our own high quality research, as well as that of other experts, we can deepen our understanding of the most important issues and help our clients make the best decisions possible amid the uncertainty.
Chart 2: A wide range of plausible paths for the global economy
Source: Haver, ASIRI (as of 2020)