The Federal Reserve will be watching the labour market before pushing the panic button
Gavyn Davies
Fed chair Jay Powell justified the rate cut on the grounds of the uncertainty sparked by coronavirus © Bloomberg
Two weeks ago, it would have seemed absurd to suggest that the US Federal Reserve would shortly introduce an emergency cut of 50 basis points in policy interest rates, with a further 50 basis points priced in by the forward market for the Federal Open Market Committee meeting later in the month.
Jay Powell, the Fed’s chairman, justified this week’s rate cut on the grounds of the uncertainty sparked by coronavirus. But normally, only in the case of a sudden, unexpected nosedive into recession, would such a turn of events make any sense.
As yet, there has been almost no stress in the financial system, usually the proximate cause of an economic crash. So what is happening?
It is always difficult to determine whether a recession is under way. Economic commentators frequently use a short-cut, which is to call a recession only after observing two successive quarters of declining real gross domestic product.
Since the first quarter of 2020 will probably record positive GDP growth, this definition will be triggered only if the second and third quarters are both negative. This cannot occur until the figures are published at the end of October. That is far too long to wait.
Alternatively, the generally accepted official announcement of a recession is done by the romantically named National Bureau of Economic Research dating committee, chaired by Robert Hall. This group determines that a recession has started by judgmental observation of some key monthly economic data releases.
In the past, its announcement has occurred between six and 21 months after the recession actually started. Again, this is useful for economic historians but not for today’s policymakers.
What are the alternatives that could help the Fed right now? Statistical models can provide probabilistic assessments that the economy is near a recession. At present, Fulcrum’s model assesses that the US economy is only 2 per cent likely to fall into a recession within the next 12 months.
But these and similar models often differ, and sometimes predict a higher chance of recession even when one does not occur. For example, the New York Fed’s model, which is based on the yield curve — a measure of the level of long-term interest rates relative to short-term rates — indicated a recession probability of 31 per cent, as of February. False signals are a familiar problem.
Economists at the Federal Reserve Bank of New York have recently tried to address these issues by examining many statistical and econometric methods that can help identify the start of a recession as early as possible in a downturn.
The signal likely to be preferred by policymakers in the real world, such as the Fed’s interest rate setting committee, is disarmingly simple and related to the labour market.
The New York Fed authors who developed this method point out that when the unemployment rate has historically jumped by 0.35 to 0.50 percentage points from its lowest level in the past 12 months, the US economy has almost always entered a recession.
It really is that simple. The authors say their method is also reliable and stable for the US economy, even in real time.
On this extremely intuitive rule, there has been no indication lately that the US is yet in recession. The unemployment rate has dropped to 3.5 per cent, the lowest reading in the current cycle and one of the lowest in the postwar period.
The good news is that it can therefore be quite clearly concluded that the US economy was not in recession, or even near recession, when coronavirus arrived in the country in February.
The bad news is that the virus has shown in China, South Korea, Italy and elsewhere that it has the potential to cause extremely disruptive and recessionary forces in any economy where it takes hold (see box for recent GDP forecast revisions).
Although monetary policy should not be the first-order response to coronavirus, it can nevertheless help stabilise markets. The question now is how long the Fed should wait before firing the last of its precious monetary ammunition.
Without clear evidence of a recession, a little patience in the FOMC meeting may be needed.
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Possible revisions in GDP forecasts following coronavirus shocks
Macroeconomic forecasters have already decided to revise downwards their GDP growth forecasts for 2020 following the China PMIs for February and the much greater spread of coronavirus in many advanced economies.
Kristalina Georgieva, the director-general of the IMF, has warned that her organisation will reduce the global growth forecast for the 2020 calendar year to below last year’s 2.9 per cent rate.
Many of these revisions are not yet published in full, but we can estimate the likely eventual extent of the changes in consensus forecasts by examining early releases from market economists, including JPMorgan and Goldman Sachs, and also the results of the latest Fulcrum modelling.
Indicative estimates (prepared by Rahil Ram at Fulcrum) suggest that forecast GDP growth for the major advanced economies may be revised down 0.6 percentage points to only 0.8 per cent in calendar year 2020, with Japan clearly experiencing a two-quarter recession, and the EU very close to it.
The US, by contrast, is still expected to maintain positive quarterly GDP growth throughout the year.
Growth in the global economy, including the emerging markets, has been revised down by more than growth in the advanced economies.
Based on the recent PMIs, Chinese GDP growth is likely to be revised down by as much as 2.0 points to 4.7 per cent, with global GDP growth revised down by 1.2 points to only 2.3 per cent.
These results would represent the lowest global growth rates since the Great Recession in 2009.
The writer is co-founder and chairman of Fulcrum Asset Management
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