As I write this the effects of the coronavirus COVID-19 are still developing. It appears this will likely become a worldwide pandemic and a lot of people around the world will be getting sick. I’m not an expert on this, I’m just echoing what I’m hearing in the news from people who should know a lot more about it than I do.
Obviously this is a tragic situation and a lot of people will be suffering. Let’s hope that something can be done to contain the disease. Unfortunately at this point that doesn’t appear to be likely, at least until a vaccine is developed and distributed. Until then we’ll be living with this disease and its effects.
So what does this have to do with the economy?
Drastic measures may be taken to contain the disease, as we have already seen in China and several other countries. Having everyone stay home and isolated means that factories are not producing goods. This results in shortages of parts to make things in other areas of the world that may not yet be affected. This is creating a supply-side problem.
People who are sick or staying home in quarantine are naturally reducing their buying. People will be cutting back on travel, shopping, and on-line buying (for fear of contaminated packages). This will create a demand-side problem.
So it appears the economy will be getting hit from both sides, both a reduction in supply and a reduction in demand.
This has already been felt in the stock market which is down significantly for the month of February. It’s difficult to say at this point how low the market will go. This is creating pressure on the Federal Reserve to “do something” to prop up the value of equities. The tweets and pressure will only increase as this situation continues, especially since this is an election year. Many investors have come to expect that the Fed will always ride to the rescue when stock prices decline.
Unfortunately there really isn’t a lot the Fed can do to help this situation. Lowering interest rates will not cure the virus nor will it cause people to go back to work and to spend money.
The most recent financial crises – the dot com bust in 2000-2001 and the financial crisis in 2008 – resulted from financial causes and were demand-side issues. In those cases the Fed was able to have some effect on improving the situation. The last time the U.S. economy suffered a supply-side shock that the Fed couldn’t fix was the 1973 oil crisis. In that case the Organization of Petroleum Exporting Countries (OPEC) proclaimed an embargo on countries supporting Israel including the United States. The supply of oil dried up and prices skyrocketed. There were long lines at gas stations. Manufacturing was also affected as many products depend on oil either in their manufacture or certainly in shipping.
At that time inflation in the price of commodities was already about 10% per year. The oil shock accelerated this inflation while also decreasing demand due to the higher prices, leading to what became known as “stagflation” (a situation with both a recession and high inflation). The Fed tried to balance their policy between controlling inflation and boosting the economy. This caused them to adjust interest rates up and down until businesses didn’t know what was happening next. So businesses just kept their prices high.
This situation continued through the 1970s until people got so fed up with inflation that they were willing to do almost anything to get it under control. The Fed finally took the drastic step of letting interest rates go sky-high, leading to a deeper recession but finally bringing inflation under control. I graduated college in 1981 and remember buying my first new car with a loan that carried an interest rate of 19%. At that time 30-year U.S. treasury bonds were paying over 14% interest.
Clearly many things are different today than in 1973. Luckily we have very low inflation (except for some things like health care and college tuition) as compared to the 10% inflation at the start of the oil embargo. On the other hand, the effects of COVID-19 will be across the board and not just in one commodity like oil.
So far the effects have been more on the supply side than the demand side since most of the world is still going about its business. This could lead to shortages and higher prices. Once higher prices are established, it’s very hard to get that trend under control as the Fed found during the 70s.
If the disease does spread as expected, eventually the demand side will go down with it. However my guess is the the demand side will be less affected than the supply side. Individuals will largely get over the disease once they have it and go back to living and spending as before. Production could be affected over a longer time period due to rolling worker absences as the disease works its way through the population.
This assumes that everyone is not ordered to stay home for months, which is difficult to imagine happening outside of China. Even China will have to give in at some point and let people out of quarantine.
So it could be that the combination of supply-side issues plus the Federal Reserve pumping more money into the system could lead to a more inflationary environment. How much inflation and for how long depends on too many unknowns at this point. History shows that inflation can continue for quite a long time since it has to get to a point where people are so fed up that they’re willing to take the cure – basically higher interest rates and a recession.
On the other side, if businesses suffer enough they may start laying people off, which could lead to a recession and decreased demand.
If supply costs remain high for businesses, we may see both layoffs and higher prices, which could put us back into “stagflation”.
I believe the most likely scenario is that prices will rise for some time and the Fed will pump more money into the system which will cause additional inflation, but eventually the disease will make its way through the population or a vaccine will be developed and the economy will slowly return to “normal”, whatever that means these days.
Or in the best of all worlds, the disease could be contained and the economy recover quickly. Let’s all hope for that.