by Robert F. DeLucia,
Summary and Major Conclusions:
- Based upon the experience of previous epidemics, the recent outbreak of the coronavirus in China’s Hubei Province will have a short-term economic and financial market impact, but one that should fade after a period of several months, assuming there are no mutations and that effective measures are taken.
- The epidemic will have a disproportionately large impact on the Chinese economy, and should also affect the surrounding countries in Asia, although to a lesser extent. The direct impact on the US economy should be mild.
- The severe reaction of world financial markets reflects the growing importance of China to the world economy and the expected slowdown in world exports. It also reflects significantly overbought equity markets in the US and around the world.
- There are several factors supporting my forecast of faster US GDP growth this year. The most obvious is the easing of trade tensions between China and the US with the recent signing of the “phase one” trade truce.
- Much improved financial conditions should also boost economic growth. Compared with a monetary tightening campaign during 2017 and 2018, the Federal Reserve eased monetary policy considerably over the course of 2019.
- It seems highly unlikely that the Federal Reserve will tighten monetary policy this year. The current strategic objective of monetary policy is to achieve faster economic growth and higher inflation.
- The Fed is also concerned that the core inflation rate has been consistently below its longterm target of 2%, and would like to raise both inflation and inflationary expectations.
- The Federal Reserve is insistent that it has not resumed quantitative easing. The Fed is splitting hairs. Incremental purchases of Treasury securities of any duration have the effect of injecting additional liquidity into the economy, and are therefore expansionary.
- The Treasury yield curve has flattened in recent months but is unlikely to invert on a sustained basis during 2020. In fact, the next major shift in the curve will likely be toward steepening, once the US economy shows clear signs of faster growth.
- The domestic economy is not unresponsive to lower borrowing costs as some believe. The most obvious benefit for the economy is the direct stimulus to housing construction. The plunge in mortgage rates over the past year from nearly 5% to 3.5% has sparked a sharp rise in residential construction.
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