The Great Saving Shock of 2020?
By Scott Sumner
It’s hard to make sense of all the various economic data that we are seeing in recent weeks:
1. A red-hot labor market, perhaps the strongest since the 1960s.
2. Rapidly falling equity prices.
3. Plunging interest rates, both fed funds futures and longer-term bond yields.
4. Reports that the Chinese economy may be back to normal by April.
Of course the backdrop to all of this is the coronavirus epidemic. (Thankfully, we don’t have to hear any more about Bernie Sanders causing the stock crash, as Biden seems to be firmly in the drivers seat. Sanders had an impact, but it was small.)
The simplest explanation is that the coronavirus epidemic may cause a recession. But that doesn’t fully explain the decline in bond yields, especially the real yield on long-term inflation indexed bonds. The impact of the coronavirus is expected to be relatively short-term. In another 12 to 18 months we may have a vaccine. Some even believe that the epidemic will moderate as soon as it warms up this summer.
Another possibility is that the coronavirus is expected to cause a radical change in lifestyle, one that involves a much higher savings rate. Thus people will be less interested in going on vacations, to the movies, or eating out. You might argue that in that case they’d simply switch consumption to other goods, buying more washing machines and automobiles. But we live in such a service-oriented economy that it’s hard for people to quickly adjust their lifestyle in such a way as to move consumption from one sector to another. Thus saving increases, depressing interest rates.
I do find it plausible that the bond market is being hit by an unusually sudden and unusually large savings shock. This theory has the same drawback as the previous theory, however, as the coronavirus epidemic is expected to be temporary. Indeed in places like China it appears the worst is already over. Perhaps the markets are signaling that the epidemic will last longer than expected, and/or that it will trigger fear of future epidemics, and that this will permanently change lifestyles.
You could argue that financial markets aren’t actually measuring “expectations” anymore, and that the enormous uncertainty about the epidemic has created a high demand for safe assets, which is boosting bond prices and reducing stock prices. According to this view, the low interest rates on long-term bond don’t actually reflect expectations that future interest rate will be extremely low. Perhaps, but we’ve been hearing that argument for 12 years, and it hasn’t panned out so far. The markets have been broadly correct on low rates being the “new normal”.
Some claim that at least 3 billion people will eventually contract the illness. If we assume a mortality rate of 0.5% to 1.0%, then this implies 15 – 30 million deaths, making it the greatest disaster since the Great Leap Forward. Perhaps wars and plagues move societies in an illiberal direction, which would be bad for long run economic growth. But this all seems highly speculative at the moment, and is unlikely to account for day-to-day moves in the financial markets. Furthermore, those mortality estimates assume another upward surge in deaths in China (reported at roughly 3000 so far, and slowing, although the actual numbers are somewhat higher). I have no idea whether there will be a secondary and far worse outbreak in China; this claim seems highly speculative.
What are the policy implications? Even with all the uncertainty, several points seem clear.
1. Equilibrium nominal interest rates are declining.
2. Equilibrium real interest rates are declining.
3. Expected inflation and expected NGDP growth are very likely declining.
The first point suggests that the Fed should cut its nominal interest rate target. The third point suggests the Fed should ease monetary policy. (And no, that’s not saying the same thing in two different ways, as NeoFisherians are fond of pointing out.). The second point might imply that we would benefit from building more infrastructure, but it most certainly does not imply that the government should be building that infrastructure.