Outlook shrouded in doubt

Initial forecasts of the pandemic’s economic impact were premised on the idea that just a handful of sectors — airlines, travel and leisure would be temporarily disrupted and that weakness would be relatively short-lived. The reality is that vast swaths of the economy are being shuttered, and the financial pain is certain to be much greater than originally expected.

The downside revisions are staggering. In its latest forecast, Toronto-based Royal Bank of Canada’s (RBC) economics department now projects a 2.5% decline in Canada’s GDP this year. Less than a month ago, the forecast was for 1.4% growth.

This much grimmer outlook includes a 3% drop in GDP in the first quarter of this year, followed by a whopping 18% decline in the second quarter with the jobless rate also jumping to 10.7% in Q2 from 6.8% in Q1.

The huge drop in output is the result of widespread social distancing requirements imposed by governments to stem the spread of the virus. This public health imperative has prompted Ontario and Quebec to lock down “non-essential” businesses, among a variety of other measures (closing schools and banning public events), in an effort to prevent a public health emergency.

“The pressure on the economy will be widespread, with the services sector hit by a severe demand shock as social distancing keeps consumers and workers at home,” states the RBC forecast. “On the goods-producing side of the economy, the disruption of supply chains and collapse in the energy sector will exert further downward pressure on [economic] growth.”

The increasingly bleak outlook is subject to significant uncertainty most important, what happens with the pandemic. The efficacy of social distancing in curbing the infection rates is not known. Therefore, the durat ion of the government-mandated shutdowns also is unknown.

Moreover, once the crisis passes and government restrictions lift, the risk of the virus flaring up again remains. Until either an effective vaccine is developed or infection (and recovery) rates rise high enough to generate “herd immunity,” the prospect of Covid-19’s re-emergence remains a genuine threat. While this is the case with any virus, Covid-19 is more deadly and more transmissible than the ordinary seasonal flu and previous pandemics, such as the H1N1 outbreak in 2009.

A research note from Montreal-based National Bank Financial Inc.’s (NBF) economics department indicates that Covid-19 spreads at about double the rate of these other illnesses. “In that context, unprecedented action taken by governments worldwide to shut down the economy, while painful, is understandable,” NBF’s note states.

Economists are trying to understand the trade-off between human health and economic growth under the threat of a deadly pandemic.

To that end, on March 18, the Federal Reserve Bank of Minneapolis published a paper that aims to bridge the gap between economics and the models public health experts are using to guide governments in their decisions to curb ordinary human interaction and business activity.

The Minneapolis Fed paper concludes that infection models indicate that “severe social distancing measures” probably will have to be maintained for a full year, and possibly as long as 18 months, to avoid severe public health consequences.

Alternatively, if governments abandon social distancing and allow the disease to run its course, the economy still may not fare any better. In that case, government- imposed shutdowns wouldn’t be the cause of lost output, and extensive death and illness would impose their own large economic costs.

“Which option would have the more severe economic consequences is hard to determine,” the Fed paper concludes.

New research into the Spanish flu of 1918-20 found that the economic and financial consequences of that unconstrained outbreak were severe, generating an average 6% decline in GDP, along with significant drops in stock and bond returns, in afflicted countries.

What is clear is that social-distancing efforts to combat the spread of Covid-19, while costly for the economy, will save lives. A new working paper from the U.S. National Bureau of Economic Research, which aimed to integrate the standard model of virus spread with economic decision-making, concluded: “It is optimal to introduce largescale containment measures that result in a sharp, sustained drop in aggregate output.”

That paper estimated that the “optimal containment policy” will save about 600,000 lives in the U.S. While the Covid-19 crisis often is framed as a binary decision between health and economic growth, economists are contemplating other possible approaches.

One option is to impose strict social-distancing requirements initially, loosen those restrictions once infection rates subside and then ratchet them up again when the virus inevitably re-emerges.

The paper from the Minneapolis Fed examined that sort of approach and found that it will probably delay the virus’s spread, but doesn’t solve the underlying challenge: “The model predicts that once mitigation ef forts are relaxed, the disease simply restarts its rapid progression and sweeps through the population in less than 18 months, reaching its peak infection rate about 450 days from now.”

So, while initial efforts to contain the virus may be successful, dialling down restrictions is likely to open the door to a new outbreak requiring governments to reinstate social distancing restrictions. However, temporarily backing off on social distancing could at least buy some time to invest in additional health-care resources (e.g., manufacturing ventilators and training workers) to cope with the next outbreak.

At this point, that’s not a scenario the newly gloomy economic forecasts contemplate. Instead, they anticipate that the severe economic consequences of social distancing will be relatively short-lived and that the economy will bounce back quickly once government restrictions are lifted and pent-up demand is released.

For example, RBC’s forecast foresees GDP growth rebounding in the third quarter of 2020, rising by 9.0% and generating 2.9% annual growth in 2021.

Expectations for a rapid rebound are underpinned by the unprecedented efforts that governments and central banks are deploying to help cushion the economic consequences of social distancing. Along with large interest rate cuts and central banks’ efforts to ensure liquidity in financial markets, governments are stepping up with major fiscal measures.

In Canada, so far this includes $85 billion in tax deferrals, $52 billion in direct spending and $65 billion in loans.

In the U.S., policy-makers are launching US$2 trillion worth of support for individuals, companies and local governments.

Globally, these efforts should support an eventual economic recovery. DBRS Morningstar Inc. states that while government measures won’t be able to fully offset the economic effects of the lockdown, they will help underpin “a relatively more robust economic recovery” that will begin later this year.