US macro outlook: Now let’s bend the economic growth curve

The current economic crisis, triggered by the COVID-19 pandemic, stands in a class of its own, very different in key respects from major past crises — including the 2009 great recession and the 1929 Great Depression, often used as comparators.

The current recession has been engineered by government fiat in response to health concerns, rather than being due to any fundamental imbalances in the real economy or the financial sector. Policymakers have shut down virtually overnight large parts of the economy — in the US and other major countries — ordering people to stop working and consumers to stay home, so as to halt the spread of the virus. This had two important implications.

First: Policymakers knew very well that the adverse economic impact of extreme social distancing would be immediate and massive, and therefore launched an immediate and massive policy response.

Locking down the economy was an unprecedented step—but the engineered nature of the shutdown also made the near-term impact much easier to predict. The degree of uncertainty was much lower than, for example, at the outset of the Global Financial Crisis (GFC). Back in 2007–2008, as the financial system started seizing up, it was extremely hard for policymakers to assess the impact of the meltdown of opaque structured financial products through the intricate interconnections of the global financial system— and the fallout on the real economy. The US Congress approved the Emergency Economic Stabilization Act only in October 2008, over a year after the bank run on Northern Rock in the UK (September 2007).

This time around, when they issued their “stay-at-home” guidelines, policymakers had much greater visibility on what the impact would be, and they knew it would happen very quickly. The dramatic surge in jobless claims was shocking, but not unexpected. The fiscal and monetary policy reaction was expected but shocking in its speed and decisiveness.

The Federal Reserve (Fed) announced open-ended Quantitative Easing (QE) and launched a new range of facilities to support the flow of credit to households and businesses. The US Congress approved a $2.2 trillion fiscal stimulus aimed at boosting unemployment benefits and helping businesses pay employees — among other priorities. It appears highly likely that more fiscal stimulus might follow soon, with an extension of the Payroll Protection Program as well as some additional support for state and local governments — negotiations in Congress are ongoing at the time of this writing. A substantial second package with an important infrastructure component seems less likely in the near future but should not be ruled out.

Second: Most corporates and businesses have assumed that the sudden stop to the economy will be temporary. This has been especially evident in the very large share of temporary layoffs in total layoffs: temporary layoffs accounted for nearly 80 per centof the 1.35 million new unemployed recorded in March.


This is important for two reasons. The first is it signals that even with the current elevated uncertainty, the working assumptions for the majority of businesses and individuals affected is that the disruption to their activity will be temporary: businesses hope to be allowed to reopen soon and to bring many of their employees back on board; workers hope to go back to their jobs. The second is that in previous recessions a higher share of temporary layoffs has been associated with a quicker and stronger employment rebound in those same sectors where the initial job loss had been steepest, as in the 1981-82 recession, which the Fed — led by Paul Volcker — engineered to eradicate high inflation.

All shapes of recovery are still possible

The combination of these two factors — the immediate decisive response of policymakers and the readiness and desire to go back to work of employees and businesses — implies that a robust V-shaped recovery is still possible — though by no means guaranteed. In this regard, we should also note that unlike in 2008–2009, a full-fledged financial crisis seems highly unlikely at this stage — and research has shown that a financial crisis makes the impact of recessions deeper and more prolonged.

To put it differently: a very high degree of uncertainty still surrounds both the depth of the recession and the shape of the recovery, and assuming that a U- or L-shaped scenario is inevitable misses the two most crucial features of the current situation discussed above. A brief parenthesis: talking about V-, U- or L-shaped recoveries can be confusing because much depends on whether we are looking at “sequential” quarter-on-quarter growth rates — favoured by macroeconomists — or at annual growth rates. In our analysis, we look at quarter-on-quarter growth, and our assessment of the recovery will focus on the ability to reduce unemployment and bring gross domestic product (GDP) back toward the pre-recession trend.

The depth of the recession and the speed and shape of the recovery hinge on three factors:

1. How quickly and with what precautions policymakers reopen their economies;

2. Whether a second wave of contagion will cause a new round of shutdowns in the second half of the year; and

3. To what extent businesses’ and consumers’ behavior will differ once the economies reopen.

Let’s briefly consider these three questions in turn.

First — Reopening the economy: The longer the economy remains shut, the larger the number of businesses that will go bankrupt or decide to throw in the towel, and the more workers will end up permanently unemployed (in the sense of not on temporary unemployment). The consequent erosion of both human and physical capital could undermine the recovery. Restarting economic activity has now been increasingly recognised as a policy priority namely because the shutdown is having a disproportionate impact on the most vulnerable sections of the population. In Europe, a number of countries such as Germany, Austria, Denmark and the Czech Republic have already announced or taken the first steps in this direction; even Spain, one of the worst hit, has allowed (some) manufacturing and construction activity to restart. In the US, the White House has issued guidelines to help states chart their individual paths. Seven East-Coast states are working together to plan a coordinated reopening — as are seven Midwestern states and three west coast states.

New COVID-19 cases and new fatalities are now declining at an encouraging pace, which suggests the US economy should be able to commence the resumption of activity during the month of May, with some acceleration in June. We should expect the reopening to be gradual. As Director of the National Institute of Allergy and Infectious Diseases Dr. Anthony Fauci has noted, “it will not be like flipping up a switch.” With the virus still active in the population, policymakers will likely reopen in a staggered way, while maintaining precautions to safeguard the most vulnerable sections of the population and prevent a rapid re-acceleration of contagion.

Second — Risk of a second wave: Most experts expect that in the fall, when the new flu season begins, the coronavirus will also come back — the question is with what intensity. Policymakers are well aware that if contagion flares up again in the fall and forces a renewed shutdown of the economy, the economic and health consequences will be catastrophic. Our working assumption is therefore that while reopening the economy they will adopt the necessary precautions to prevent it. This will encompass efforts on several fronts: antibody testing, therapy and vaccines. We treat a second wave of contagion intense enough to cause a new shutdown as a tail risk.

Third — Changes in business and consumer behavior: Will people be a lot more reluctant to travel by plane, go to bars and restaurants, take public transport and live in big cities? We believe to some extent the answer is yes, at least in the first few months after the economy reopens. But the intensity and duration of behavioral changes will likely vary across age brackets, reflecting different risk factors, and across countries, reflecting different cultural specificities. We build this into our assumptions on the different pace of recovery for different sectors of the economy.

A recession that targets the most vulnerable sections of society

To build our scenarios, we assume that US policymakers will start to gradually reopen their economies in May, with the pace at which different sectors are allowed to restart accelerating in June.

The US economy had entered 2020 in robust shape, with a record-strong labor market, rising household incomes and record-high equity prices. In early March, however, high frequency data showed the first signs of weakness in the sectors most exposed to the COVID-19 crisis: leisure and hospitality, travel and wholesale and retail trade. Within less than a month, as a number of states issued “shelter in place” orders, activity in several sectors came to a halt and unemployment surged: jobless claims soared to a cumulative of over 22 million by the second week of April, from an average of just over 200,000 over the previous twelve months. Business uncertainty spiked, and both business and consumer confidence plummeted.

The shutdown has affected disproportionately the most vulnerable sectors of society: job losses have been much heavier for less educated, lower-skilled workers and for African American and Hispanic minorities. These categories of workers had been the last to start benefiting from the tight labor market through better jobs and rising incomes, and they generally have very limited financial cushions; the Fed Board’s 2016 Survey of Consumer Finances showed that about 25 per cent of these households have less than $400 in liquid savings, and 60 per cent do not have sufficient liquid savings to last at least three months.

Similarly, workers in the four industries most affected by the shutdown (leisure and hospitality, retail trade, transportation and other services) have median incomes below the nationwide $48,700 level — and they account for nearly 30 per cent of the workforce.

Policy reaction: both cushion and stimulus

The policy reaction, as mentioned in the previous section, has been equally swift: just two weeks after President Trump declared a national emergency (13 March), Congress approved the Coronavirus Aid, Relief and Economic Security Act (CARES), mobilising over $2 trillion to boost unemployment benefits, help businesses meet payroll, and get cash into the pockets of households impacted by the shutdown. The Fed had moved even earlier, announcing open-ended QE, and followed up with a new set of facilities to unlock up to $2.3 trillion in lending to households, businesses, financial markets and state and local governments. The Fed’s balance sheet has already expanded by $1.8 trillion in a few weeks, to a new record high of $6.1 trillion.

The focus of both the monetary and fiscal response has been to minimise the adverse impact of the temporary shutdown, helping businesses to remain operational and helping people meet their financial obligations, providing a financial lifeline during a period of income loss.

The policy-provided income support is substantial. The Pandemic Unemployment Assistance (PUA) under the CARES Act more than doubles the nationwide average Unemployment Insurance benefit of $356: workers claiming unemployment insurance benefits will be entitled to an additional $600 per week for up to four months.

This will help replace a large share of the pay of low-wage workers; in fact, (a) in certain states overall unemployment benefits will exceed the pre-crisis weekly wage of some workers, as you can see in the chart above; and (b) nationwide, the enhanced unemployment benefit will exceed average wages in the leisure and hospitality industry by 80per cent and by 30 per cent in retail trade.

This highlights a very important point: to the extent that this financial assistance gets delivered in an effective and timely manner, it will not just provide a cushion but will in fact give a boost to the purchasing power of certain groups of people — acting more like stimulus than like insurance.

Recovery scenarios

There is of course an important degree of uncertainty as to how effective the fiscal response will be. We have therefore simulated two different scenarios: one with “moderate pass through” and one with “strong pass through.” As a benchmark, we have also built a counterfactual “no fiscal stimulus” scenario (or a completely ineffective fiscal policy), to gauge the estimated impact of the fiscal response.

In all three scenarios, our projections are built by looking at gross value added and employment in eleven major industries. Moving from no fiscal stimulus to moderate pass through to strong pass through we assume both a stronger recovery in employment and a more robust recovery in productivity. In all three scenarios we assume the same sharp rise in unemployment and significant decline in productivity in both the first and second quarter of 2020.

We assume that leisure and hospitality, wholesale and retail trade, and professional and business services will be the hardest hit, but that all eleven industries will suffer heavy job losses between March and June this year, pushing the unemployment rate to about 15 per cent.

We estimate a real GDP contraction of nearly 9 per cent in the first quarter of 2020 and forecast a further near-30 per cent drop in the second quarter.

In the absence of a fiscal response, our scenario assumes that only half of the jobs lost would come back by the middle of next year, leaving the unemployment rate above 9 per cent. The recovery in GDP would be correspondingly weak, looking more like a U-shaped recovery. The US economy would contract by nearly 6 per cent this year and expand by less than 3 per cent in 2021.

In our moderate fiscal pass-through scenario, the economy would recover three-quarters of the total job losses by the middle of next year. Even a moderate pass through allows for what looks like more of a V-shaped recovery, with annualised quarter-on-quarter growth of 16 per cent in the third quarter and 11 per cent in the fourth quarter of this year. Under the moderate pass through assumption, fiscal support cushions the blow in 2020, limiting the contraction to just under 5 per cent, and results in a 4.5 per cent GDP expansion in 2021, with the unemployment rate falling to 6.5 per cent by the middle of next year.

In the strong pass-through scenario, the economy recovers nearly 90 per cent of its job losses by the middle of next year, bringing the unemployment rate down to 5 per cent. The GDP recovery follows a V-shaped path, with a 20 per cent expansion in the third quarter of 2020 followed by a 15 per cent expansion in the fourth quarter; the fiscal response limits this year’s recession to “only” 4.5 per cent, followed by a 6 per cent expansion next year.

Note that even in the strong pass through scenario the economy does not get back onto its pre-recession growth path by the end of next year (and 3 million of those who lost their jobs in the recession are still unemployed). The hit from the March-May shutdown is so severe that even if a gradual reopening of the economy begins in May, and even with a massive and timely fiscal stimulus, the economy will not have yet fully returned to its pre-crisis growth trend even at the end of next year.

Looking beyond 2021 however, if the fiscal policy pass through proves to be strong, a large part of the damage may well have been mended, and the economy could be back on a solid expansion trajectory.

We should also stress that in our scenarios we have focused on the fiscal policy response, and we have not modeled the impact of the equally decisive monetary policy response we therefore see potential for some upside above our forecasts.

Health uncertainty and economic uncertainty a hard trade-off

Overall, our simulations underscore the high degree of uncertainty that we still face.

While a short and sharp recession is already baked in the cake, many different shapes of recovery are still possible.

Policymakers face a difficult trade-off between health uncertainty and economic uncertainty.

If they reopen the economy in a timely and smooth way, the massive fiscal and monetary stimulus in the pipeline could fuel a very strong recovery over the course of the next six quarters. This requires accepting some uncertainty on the contagion front — but with the right precautions would be feasible. At the other extreme, prolonging the shutdown reduces the virus-related health uncertainty, but increases the risk that rising bankruptcies will increase the share of permanent job losses and lead to a much slower and weaker recovery. We should also bear in mind that a deeper and prolonged recession will carry its own health costs — recessions are associated with a rise in suicides, drug-related deaths, depression and domestic violence.

To fix ideas, the following chart compares our three scenarios to the actual recovery from the GFC. If fiscal stimulus proves ineffective, after an initial rebound the economy would settle on a lackluster growth path not dissimilar from that post-GFC. In our strong pass-through scenario, by comparison, the US economy could stage a much more decisive comeback than 10 years ago — capitalising on the very different nature of the current crisis.

An additional layer of uncertainty lies in the differential speed of recovery of the demand and supply side of the economy, with important implications for price dynamics. Over the next few months it is hard to imagine any upward pressure on inflation. If a strong recovery materialises, however, we need to watch for the possibility that the recovery in demand could gradually result in sustained inflation pressures in light of the substantial monetary and fiscal policy stimulus. In addition, the economy will emerge from this crisis with a massive fiscal and monetary overhang — a much larger Fed balance sheet and an increased ratio of government debt to GDP. This is likely to generate imbalances and dislocations that financial investors will need to monitor and eventually factor into their strategies.

Over the coming weeks, we should of course continue monitoring the trend in new cases, hospitalisations, intensive care unit use and fatalities across individual states. Data over the coming two weeks will hopefully confirm that most if not all states are moving past the peak, leaving the worst behind. But it will be important to keep monitoring these data to check that as social distancing is relaxed and economic activity restarts, any resurgence in contagion remains limited and controlled. Similarly, sustained progress in boosting hospitals’ capacity and further improving testing capabilities will be important to underpin the sustainability of the recovery.


We are tackling a crisis like no other. This implies that we face a whole new set of challenges, but also that we should not assume it will be a replay of the worst past recessions — though that risk exists. Any shape of recovery is still possible. The initial swift and massive policy response puts a robust economic recovery still within our grasp.

To achieve it, we believe policymakers need to reopen the economy in a timely manner and with the right health precautions. A smart and speedy restart of economic activity can protect those most vulnerable to the virus and safeguard those most vulnerable to the catastrophic health and economic consequences of a deep prolonged recession. This paper has laid out the alternative macroeconomic scenarios that we believe might still play out — and that form the fundamental analysis backdrop against which we are framing our investment strategy.

Sonal Desai, chief investment officer, Franklin Templeton fixed income

US macro outlook: Now let’s bend the economic growth curve
Sonal Desai
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