Mar 18, 2020

James Sweeney on the Money View Framework and COVID-19’s Implications for the Macro Economy

The money view framework is an increasingly important tool for understanding the current economic crisis and what type of recession we might experience in the future.
David Beckworth Senior Research Fellow , James Sweeney

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

James Sweeney is the chief economist at Credit Suisse and joins us today as a part of our ongoing special coverage to talk about the coronavirus or COVID-19 and its implications for the economy. Specifically, David and James discuss what this pandemic means for the plumbing of the financial system, interest rates, and the type of recession we might experience.

Beckworth: Our guest today is James Sweeney. James is the chief economist of Credit Suisse and joins us today to talk about the coronavirus or COVID-19, and its implications for the economy. Especially, what it means for the plumbing of the financial system, interest rates and the type of recession we might experience. James, welcome to the show.

Sweeney: Thank you. Very happy to be here.

Beckworth: Glad to have you on. Now, we have interacted over several years in fact, going back to my blogging days, which are kind of in the rear view mirror, I haven't been blogging a lot lately. But nonetheless, you were very generous with your time in the past and you're generous today, taking time out to talk with me, even though markets are tanking all around and you're very busy. So I'm excited about this because you are part of the group that espouses the Money View shared by Zolton Pozsar and Perry Mehrling. So I'm excited to get to that in a minute. But before we do, maybe tell us a bit about what you do and how you got into it.

Sweeney: Yeah, sure. So, so I've been at Credit Suisse for just about 20 years now, I joined in 2000. I worked in London for a long time as a fixed income macro strategist. I move over to New York in beginning of 2007, and had the great fortune of not having a team in New York. So Credit Suisse plopped me at the end of the repo desk, and from some of my old academic interests, I, at LSE, studied under Charles Goodhart and Nobu Kiyotaki, just for a year.

Beckworth: Oh wow.

Sweeney: But I was very interested in monetary theory and history, and have always been. And sitting next to a repo desk in the crisis was a very good place to be. And I was collecting haircut data by hand, I was thinking about collateral, I was thinking about some of Kiyotaki's papers and rereading them, until I started to understand them a little bit. And sort of found over time, various people who were connecting with each other and thinking about the crisis. And Perry was a professor, doing some very interesting work on the crisis, he wrote a book on it. Zoltan was at the New York Fed at the time, he was mapping it out. I was thinking about money-ness of different types of securities and getting my hands on haircut data before it was cool. And so we all built out our different frameworks for thinking about it and wrote a bunch of papers and that has gone a certain way, but it wasn't really the day job. It was how I focused on the crisis.

Sweeney: My day job continued to be really thinking about markets and how it interacted with the economy. And over the past 10 years, I ended up becoming the chief economist for Credit Suisse. We now have around two dozen economists around the world. I have a team in New York. We do a lot of work on the real side of the economy. And in four or five years ago, I had the opportunity to hire Zoltan who really goes in very, full-fledged on money markets and really just a deeper institutional understanding of the plumbing of funding markets and all that. I'm still very interested in that, but my day-to-day work is really the kind of broader topics that a chief economist of a bank has to cover.

Beckworth: Well that's an amazing career trajectory. I mean, it's great that you had Goodhart and Kiyotaki, those are legends, right? Those are some pretty big names.

Sweeney: I'm aware.

Beckworth: Yeah, that's awesome. And then, you got to sink or swim in the deep end of the repo pool 2008, so that's another great experience. And then, I imagine you along with Zoltan, were very busy this last fall with all the problems in the repo market. I know Zoltan was, he was seemingly everywhere talking about it, but you guys were in the same department. You also are writing about this as well for Credit Suisse. Fascinating time to be alive.

Beckworth: Now tell us just a little bit about what you do as the chief economist. Do you report to bank officials, to traders, to investment decision making committee? How does it work?

Sweeney: Yeah, so I mean, it's really the ordinary job of a chief economist at a big bank. The department is forecasting all the usual stuff, GDP growth, central banks, inflation. We have models, we have a big team, but we're also guiding the internal risk of the bank in different ways. I'm actually also the regional CIO for the Americas with Credit Suisse, I have a seat in Credit Suisse's investment committee, which is actually the wealth management part of the bank in Zurich, even though I'm sitting in New York. And what I'm doing day-to-day is really writing notes for asset managers, and hedge funds, and pension funds and those are going out broadly.

Sweeney: We have a distribution list of something like 25,000, but it's institutional. It's not really for a retail audience, but we do deep probing stuff. And I think, focusing on industrial production and the goods sector in the short term, is very helpful for just the movements in markets, and that has given us some differentiated content. The financial and plumbing money stuff that Zoltan leads now, gives us some differentiated content as well. And we're doing all the ordinary content of forecasting the usual lead indicators and GDP at the same time.

Beckworth: Sounds like a fascinating job. And today, you're here to talk about the coronavirus and what it means for the economy. And just to be clear for our listeners, we are recording this show on March 11th and even as we speak, the World Health Organization has declared the coronavirus a global pandemic, which has its own legal implications for contracts and businesses, so likely to exacerbate matters. In fact, the market sold off 4% or so today. And so, things aren't getting any better, but they're kind of ugly out there. And just to recap also in terms of like the stock market, it's down quite a bit. Oil prices are down, 30 to $33 a barrel. Treasury yields are all pushing down towards zero, 10 years under 1%. So a lot of things are happening and you are again, in the midst of all of this. And you have a great framework from which to think about this. You have this framework called the Money View. Again, it's shared by you, you mentioned Zoltan, Perry Mehrling.

Beckworth:  And for our listeners, before we get into the actual issues, what's happening right now, help us understand this framework. What is the Money View?

The Money View Framework

Sweeney: Sure. Well this is Perry Mehrling's phrase, Perry's now at Boston University. And I guess the idea is just to focus on payments, movements of money, as a relevant variable and thinking about the economy. So we're not just looking at prices and allocations of things. And also to pay attention to the institutions of financial markets. So, if in between a saver and a borrower, there's a credit intermediation chain of many steps, we want to know what the flow of money looks like, what the flow of collateral in the opposite direction looks like. What are any constraints that arise on that chain may be from regulations or from other sources. The terms and conditions attached to interest rates, that are often not in a textbook way of thinking about the economy. So it's just really being more sensitive and aware of the plumbing and that at the heart of everything happening in economics, there are money flows which can stop and get choked up or can get distorted by various things very quickly.

It's just really being more sensitive and aware of the plumbing and that at the heart of everything happening in economics, there are money flows which can stop and get choked up or can get distorted by various things very quickly.

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Sweeney: Perry's phrase he likes to use is, "Liquidity kills you quick." So I think this is not a new perspective. In fact, in Perry's work, he shows, he actually loves talking and writing about economists who were thinking this way, many, many years ago, maybe decades ago. But I think that, in my way of thinking about it anyway, is just more sensitivity to payments and more sensitivity to institutions is the simplest way I would put it. I'm not sure if Perry would put it differently, maybe he would.

Beckworth: Well, I like this, because it takes money seriously. And you guys defined money broadly though, not just kind of a textbook measure of money, but you define it more broadly. You look at institutional money assets as you mentioned, but I like this, it's a refreshing take. You take the payment system seriously, you take money seriously, you take financial intermediation seriously. And some of this, for me at least, I know it's not exactly the Money View Perry Mehrling has in mind, but some of this takes back to like David Laidler's work or Leland Yeager, and just very familiar and in spirit at least. And I like what it does and what it accomplishes. But let me ask this question, what does this framework help us see, that the mainstream view didn't tell us, say about the 2008 crisis. How would it be helpful there?

Sweeney: Well, I mean, I remember when I was reading rereading Kiyotaki's stuff during that crisis and trying to think about it. In collecting haircut data, I came across a paper by John Geanacopoulos in 2003 or 2004, which was very technical and mathy. But the idea was that, there's not just one price, it's not just an interest rate. There's an interest rate and a haircut and they both can move. And once you start to realize that, then these prices and these interest rates you're looking at mean a lot more and are a little more subtle and complicated. And then during the crisis, those haircuts did precisely go into motion. And what I learned from Kiyotaki's papers, was that you can use a haircut as a sort of measure of the money-ness of a piece of collateral.

Sweeney: So I think that perspective is important for thinking about the crisis. And I had created various indices of different stocks of debt outstanding and using the market haircuts at the time, or at least what I was able to see, as a measure of the money-ness and to think about the money-ness of what I called it the shadow money of corporate bonds or non-agency mortgages going away. And then, you have this big injection of safe assets, safe money-like assets, as the deficits blew out, and then ultimately central bank balance sheets grew later. So I think it's just a more fluid perspective on things.

Sweeney: But 10 years later, I don't think this is a critical element of today's economic risks. We think haircuts are more stable, more regulated, more focused on the data even exists, you can get that data. And a lot of what Zoltan's looking at now, is really about the constraints on different kind of institutions and how Basel III has transformed the whole landscape for safe assets. And so, now we have a crisis with the coronavirus where the demand for dollar funding is once again perturbed and people's actual holdings of cash, are suddenly much more or much less than they expected because this is a very large payments shock to the global economy. And so we're thinking about how could the new rules, how could the circumstances of funding markets now interact with this payments shock, and can that give us a broader macroeconomic shock or even financial shock. Can it shape the policy responses we get? These are the kinds of questions we are asking right now.

This is a very large payments shock to the global economy. And so we're thinking about how could the new rules, how could the circumstances of funding markets now interact with this payments shock, and can that give us a broader macroeconomic shock or even financial shock. Can it shape the policy responses we get?

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Beckworth: Yeah. Let me peel that back just a little bit more. So your emphasis, Zoltan's emphasis, is on the payment system and what implications does this coronavirus shock have for it. And you had a great line in several of your pieces, you had one with Zoltan and you had another Credit Suisse piece, where you use this line, "The global supply chain is a payment chain in reverse."

Sweeney: Yes.

Beckworth: And I think this is important. I want you to maybe flush that out for us a little bit, but because there was this debate when markets first began to tank a few weeks ago, well this is a supply shock, just let it be, it's not a demand shock, but I think what this gets at is, you really can't separate the two out very easily.

Disruptions in the Payments Chain

Sweeney: Correct, and this is where manufacturing is special. So, when we are forecasting financial markets and even policy decisions, we go into great detail on forecasting the short term growth of global industrial production, with attention to weights and how it's evolving.

Sweeney: So we have a whole, very large body of work, in studying and forecasting these global industrial production cycles, and they have very significant correlations to interest rates, commodities, monetary policy decisions, equities. And interestingly, these correlations, when you look at them over many decades, they haven't really been declining, they're in the same ballpark. The correlation between the 10 year yield and global industrial production growth, is not that far from where it was in the sixties. So if you look at industrial production index that's value-added. If you look at total output of the manufacturing sector say, you're really looking at something more like total sales. And you could take the manufacturing sector and you could say what's the ratio of total output to value-added, right? Either real terms or nominal terms. And what you see is that ratio is very big. So it's much bigger than in the services sector.

Beckworth: What does that tell us, that it’s so big?

Sweeney: It tells us that there's a lot more sales and payments per unit of value-added in manufacturing, than in services industries. And then, if you look at the Chinese economy, where manufacturing is a much larger share of the overall economy, and where whole supply chains are. How many payments out of the total payments from the business sector in China, are associated with manufacturing? This has to be very large. And so, the idea that if you have a supply chain, there's one thing adding up the value-added across the supply chain, but it's another thing adding up the sales across the supply chain. So the money flows associated with the supply chain are out of proportion, they're bigger. And I think this is why markets have these high correlations. And that's why I went into Zoltan's office and I said, "A supply chain is a payments chain in reverse” and this coronavirus crisis, which looks like it's going to cause Chinese trade volumes to fall by, maybe double digits in the first months of this year. And Chinese industrial production to fall by, we're estimating right now, more than 5% just in a month in February, which might sound small, but it's actually pretty huge.

A supply chain is a payments chain in reverse.

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Sweeney: What is the payments disruption? How many firms and households are not going to be getting a normal payment, making a normal payment, receiving a normal revenue this month. And then, what are the global effects from that? This is a big payment shock.

How many firms and households are not going to be getting a normal payment, making a normal payment, receiving a normal revenue this month. And then, what are the global effects from that? This is a big payment shock.

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Beckworth: Yeah, this is interesting. So, just to summarize what you've said, even though manufacturing as a share of the economy hasn't been declining, at least in the U.S., on China you mentioned it's still pretty large, but in the U.S. it's been declining, what's important is that manufacturing still has a lot of transactions. So the number of total sales associated with the actual final value added in manufacturing is very, very high, which means lots of money is needed, lots of payment is needed, and if you disrupt manufacturing, you're going to have some major problems. Again, going back to your clever little statement, "Supply chain is a payment chain in reverse," or I think old monetarists would say, "Money is one side of every transaction." And I think what you're saying here is, there's a lot of transactions surrounding manufacturing, particularly in China.

Sweeney: Yeah, yeah. And then you get into, "Well, what does that mean if these transactions aren't happening?" And then it's kind of obvious what that means, people aren't paying their bills, which means some people are going to have more cash balances than they thought they would, and a lot of people are going to have less. And this is people unable to service debt, all that stuff. And that's where forbearance by banks can come in. But let's amplify this shock globally now, and think about how this goes up to banks. I mean, we're going to have companies, corporate cash balances falling, we're going to have companies drawing on their revolvers from banks. And this is going to happen across jurisdictions and in multiple currencies. And so, some institutions may find themselves short of dollars.

Sweeney: We wrote this note a couple of weeks ago, and since then we've seen some signs, we've seen some volatility in the cross currency basis in different currency pairs. A cross currency basis is sort of violation of covered interest parity, and so we've seen some of that. We've seen a little bit of volatility in funding markets. We've seen some central bank operations consistent with concern. We've seen the Japanese, for instance, the BOJ lending dollars against pooled collateral. So this is the payments problem response and implication starting to show. And how bad this will be, is this a financial crisis brewing? We're not saying that. We're not saying that. We're simply saying that in between a real economic shock and credit and default problems, there's a lot of interesting stuff. And that interesting stuff can, that can create dynamics of their own, which are very worth being aware of if you're involved in financial markets, and I think that's what's happening right now.

Beckworth: Yeah. Again, I'm so taken back because this approach really takes money seriously, which for the longest time has been missing in the kind of modern macro analysis, it's kind of a standard new Keynesian model. There is no money, well it's in the background, it's hidden, it's dropped out, the LM equation. And kind of the old monetarists did take money seriously, and I think this is along the same line, again, a slightly different focus, but I find it fascinating. And I also find this fascinating again, because it highlights that it's hard to separate a pure supply shock from the demand shock, they go hand-in-hand. And one question I had along these lines is, do you think this inability to cleanly separate these shocks has become more of an issue with globalization and the closer interlinking of economies since the early 2000's when China joined the WTO and the world's become more connected?

Sweeney: You mean separating the supply shock and the demand shock?

Beckworth: Yeah, it's gotten harder to do that because we've become so much more connected globally.

Sweeney: Maybe, I don't know. I mean, the way I've been framing this when I speak to our clients, is that China really did shut down a large portion of its own economic activity, told people not to go to work, et cetera. That's clearly a supply shock, right? And you worry about a demand shock associated with it, but the 5% drop in Chinese industrial production that we are estimating in February is sufficient to give you a global industrial production shock in the neighborhood of the 2001 recession already. Especially when you spread that shock over China's trading partners, and we think that's hitting the data now. And we've now had some trade data from China, the trade data, Chinese trade data, being relatively high quality data, confirming a significant shock. But I think the demand side is really how we look at the shock in front of us now, what's happening in Europe and the U.S. now, which is that a fear of contagion is likely leading people to cut back on risk-taking and sort of ordinary cyclical macro stuff like business investment, durable goods consumption, is likely to show some weakness in the months ahead throughout the world as people are just afraid of the virus and uncertain about the outcome. So, I think that's different from what's happened in China, but I'm sure there's plenty of risk aversion in China too.

Sweeney: And I can tell you right now, that I am right now in my house about half a mile from the perimeter of the New Rochelle containment zone in New York. And from my house it feels a little bit like a supply shock. Although Skype is currently allowing me to be pretty productive from my house because I've been on the phone all day long.

Beckworth: Oh, this is great. No, so yeah, a pure supply shock, a simple textbook model, we'd expect prices to go up, right? So I want to go buy my new iPad, it's going to be more expensive because China has shut down for a month or so overseas not producing it. On the other hand, the demand shock, kind of a textbook model, would imply lower prices. And if you look at, for example, break-even inflation, it's showing a sharp drop in expected inflation in the future, which suggests to me, and I know you've got to be careful how you interpret those, there's liquidity premium baked in as well, but it suggests that demand might be falling in the future. So, it does look like there's a reason to be concerned about a sizeable demand shock independent of what has happened in China.

Sweeney: I absolutely agree with that. I'd be careful with break-evens, but I guess you caveated that.

Beckworth: Well yeah, with break-evens to be clear, like I said, liquidity premium is a big part of that, but even a heightened liquidity premium suggests that demand might fall in the future. People are increasingly risk averse, I mean we see it in treasuries falling. There's a lot of reasons to be concerned that people are going to cut back on spending, like you mentioned, investment spending, maybe even household spending in the future. I'm going to move to the note that you wrote with Zoltan.

Beckworth: I want to read the introductory paragraphs because I think it's great and it speaks to some of these problems, but it's nicely worded and it starts like this, "Today's liquidity conditions are like the waters receding before a giant wave. The coronavirus outbreak and the shock that preventative measures introduced to manufacturing and services activity will lead to missed payments globally. Our main concern is about missed payments of U.S. dollars globally as local central banks can deal with missed payments in local currency fairly easily. Dollar funding is always the orphan child of crisis as regions where the pressures flare up have no control over it, and the Fed, uncomfortable with the reality of it being the de facto central bank of the world, takes time to step in." So, we have these orphaned child parts of the crisis, so explain that to me, and why is that so important for the Fed to understand it?

Impact of Missed USD payments in Global Economy

Sweeney: Well, I mean the dollar is still the global currency, the critical currency both to financial markets and to real trade globally. And the Fed is uncomfortable being the global lender of last resort or even worse, the global dealer of last resort. And I think a lot of the post-crisis developments did try to put the Fed at arms length to basically affect exposures in the rest of the world. And now we have shock where we have to think a little bit again about, are people going to be short dollars and desperately going into markets to access dollar liquidity, and are banks that have ample dollars to lend, are they going to be willing to lend into some of these shocks? I mean that was Zoltan's language you just read.

Are people going to be short dollars and desperately going into markets to access dollar liquidity, and are banks that have ample dollars to lend, are they going to be willing to lend into some of these shocks?

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Beckworth: Okay.

Sweeney: I don't-

Beckworth: Colorful.

Sweeney: ...fully, yeah, he's a little more colorful than I would probably be, but I think the idea is that the Fed is not there to solve everyone in the world's problems with dollar exposures. And so, you're going to rely on local pools of cash that can lend and this might be a government's foreign exchange reserves, it might be a big tech company that has the short term assets to lend to its own supply chain to keep it functioning. And, but for that to happen, so let's say a big tech company or a government with reserves, let's say they have lots of two, three, four year mortgage backed securities and investment grade bonds, they need to repo those or sell those in order to get a bunch of cash to lend to their supply chain. Doing so, pressures bank funding markets, right? Because the banks need to fund the cash outflows.

Sweeney: So, we're just asking, "What's the scale on which this thing is going to happen?" I'm not sure, but I think we're at least asking the right question, and a question that some people will miss. Again, we're not expecting a crisis, a funding market crisis, but we have seen certain sources of volatility in funding markets in recent days, this is getting increasingly interesting. And now as the demand side shock, I guess as you would say, in the West is becoming more apparent with the increased contagion, we need to continue to focus on all these things.

Beckworth: Yeah, and one of the obvious solutions to this problem is for the Fed to issue more currency swap lines, or dollar swap lines, which it doesn't want to do for obvious reasons. But you mentioned at the end of that note, the ECB, the Swiss National Bank, the Bank of England, Bank of Canada, Bank of Japan, they already have the dollar swap lines. And in my mind, the big glaring hole in that list is China, and I know it'd be a very politically challenging and risky endeavor to give them a swap line, but isn't that one of the tensions of having dollar dominance? I mean, the dollar continues to grow in importance and yet there's not a central bank willing to... the Fed itself is not willing or able maybe, to be that lender of last resort if push comes to shove.

Sweeney: Yeah, I mean Perry calls it the dealer of last resort.

Beckworth: The dealer of last resort, okay.

Sweeney: So, because it's more a capital markets function, right, than a kind of-

Beckworth: Yeah.

Sweeney: ...you're not taking in bank loans from local banks. You're bailing out securities markets on the other side of the world. But yeah, but I mean, fortunately for China, they do have ample foreign exchange reserves, they do have a lot of securities they can repo. I'm sure they have lots of short term cash. And I think they are likely using what resources they have to help some of their companies in need, some of which are state-owned. So, but again, just because that can happen, doesn't mean we shouldn't think about it. And it's not just about China, it's about really all the Asian economies and everywhere else that you're going to have. The real question is, start with a balance sheet, Perry likes to think about things in terms of risk exposures. So instead of thinking about a balance sheet in terms of money market funding of some longer term security, why don't we think about the net exposure of duration risk or credit risk or even liquidity risk, which is a little bit harrier that an individual institution has, and how does that net exposure change following a given shock and how do you respond?

Sweeney: And the usefulness of thinking in terms of net exposures is that you bring in derivatives, right? Because you can look at somebody's balance sheet and say, "These are your liabilities, these are your assets, this is your net dollar exposure," but maybe you're hedged. Maybe you're hedged in some kind of derivatives contract. The ideal state of the world from this money perspective would be an economy where you can map out the money flows, the collateral flows, and the risk flows, so you understand, what are the duration risk and currency risk and liquidity risk exposures that each institution has? Of course, it's completely implausible to ever have that kind of knowledge of financial institutions.

Sweeney: But if you imagine a world where we did, the way you approach macroeconomics and your expectations of what's going to happen in a shock, would probably be pretty different from what Orthodox macro would say. And if you're sitting inside of a big bank or a big broker dealer with global operations, you have a little bit of an opportunity to understand where some of those exposures might be because you're talking to so many people managing the operations of a broad set of different types of balance sheets and organizations.

Beckworth: So one of the arguments I've heard for why the Fed should expand the number of dollar swap lines, including places like China, you mentioned China has a lot of dollar reserves, which is true, but if you would extend the swap lines, it would reduce demand for dollar denominated assets abroad or the demand for safe assets if you knew there was the swap line available in your country, if a crisis did emerge. So maybe China wouldn't be holding as much, and as a result there wouldn't be these trade imbalances and so forth. So I'm wondering what your thoughts are on that. Does the money… if you have any light to shed on that, that maybe this is a precautionary measure, the Fed should extend the number of dollar swap lines.

Sweeney: Well, I'm not making that argument. I mean, there's a lot of politics involved there. And even if you have those swap lines available in a certain state of the world, would the other country have the faith that it will always be there?

Beckworth: Fair point.

Sweeney: So, I don't think that's some kind of panacea to give us a perfectly functioning world.

Beckworth: Okay. So we've been talking about the Money View and how to use it to make light of the current crisis, the coronavirus, now pandemic officially declared by the WHO, what do you think it means for the type of recession we're likely to encounter? So you have a note that talks about a V-shaped recession, so maybe explain what that is to our listeners and what are the chances we have that versus something else?

What Type of Recession Will We Encounter?

Sweeney: Sure. And let me just say, this is the real side of the economy now. I think this payments problem and these risks arising from lots of missed payments around the world, this is generating a potential source of tail risks later on.

Sweeney: But I think right now, money markets and funding markets are behaving in an orderly way. They're showing a few little warning signs, but this is not central to our core view of what's going to happen in the next few months.

Right now, money markets and funding markets are behaving in an orderly way. They're showing a few little warning signs, but this is not central to our core view of what's going to happen in the next few months.

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Sweeney: So this is just, what do we think about the real economy right now. And on that, the way I like to approach things is to start with industrial production, because I think it tends to drive a lot of the volatility in the economy. And I think if you can forecast a trough in global industrial production growth, you're going to help people by understanding when the cycle will start to turn a little bit. But there's a pretty stupid distinction here that I imagine a lot of your listeners will laugh at, but the reason we said the industrial production growth is going to be, global industrial production growth is going to be V-shaped, is because we're really looking at a rolling three month growth rate and February and March are likely to be so bad that when February and March fall out of your three month growth rate, the growth rate of global industrial production is likely to be getting less bad in a hurry, which is a completely banal and ridiculous argument.

Sweeney: However, what we find consistently is that that point in a cycle where growth goes from contracting and getting worse to getting better, but maybe still contracting, that's the important moment. And GDP is typically calculated quarter on quarter annualized. We call it global industrial production momentum. We're aggregating global IP across dozens of countries, weighing them properly and momentum is three month on three month annualized growth, so essentially the same as GDP. And that cadence of growth rate is what PMI's are measuring too. So if you have a trough in global industrial production growth in April or May, then you should see PMI start to turn then.

That point in a cycle where growth goes from contracting and getting worse to getting better, but maybe still contracting, that's the important moment.

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Sweeney: We could show you, the correlations are high usually, between PMI's and industrial production growth. So we expect the PMI's to fall sharply now. Lots of bad data on global trade and global industrial production in the near future. This is at first driven by the shutdowns, the preventative measures in China, but next we'll see what's the shock to really the demand side in the rest of the world. So this is auto sales going down, equipment investment going down, mining and energy structures investment, given the oil price shock, going down. So this is a further negative shock to global industrial production. But our view is that if we're lucky enough that the contagion is not continuing to worsen globally late in the spring, then you'll probably have had your worst three or four months by then and things will start to get less bad.

Sweeney: And that's where you get a dramatic V-shape on a chart such as a PMI or a global industrial production growth rate or even the growth rate of US GDP. So, in other words, we're now forecasting, I say this with great hesitancy because big error bands around all forecasts, but we've just moved our forecast to minus 0.9% for Q2 US GDP. And we think that's going to be a lot worse than Q1 GDP or Q3 GDP. Famous last words, right? Big error bands, this is short term high frequency stuff. But in that sense, V-shaped. I think you may get V-shaped in a number of these indicators, but ultimately, we're asking what kind of fragilities are opening up, what are the policy responses you have during this period and what does it tell us about the rest of the year? And I can tell you that from past cycles, when you have very weak global industrial production growth for a while, and we have, even before this crisis, we had basically an 18 month slump, driven by weakness in the global auto sector and the trade war, especially the trade war. So, you've barely started to recover from that slump in December and January, when you're hit by this new sharp shock. So you've had really, really low manufacturing production for over 18 months now.

Sweeney: So we're expecting this weakness in the next couple of months. We're watching the contagion. In the very near term we're going to have a combination of bad news confirming the depth of the recent slump, plus probably some contagion news in the US where you are testing a lot more people. So it seems like markets are going to be in a rut right now, but if we can contain the spread of the virus, maybe things will be getting better by the summer. And maybe adding a bunch of policy stimulus in various forms, you have triggered a rebound later on if you can avoid financial side effects of this crisis that are severe and persistent.

Sweeney: So we see it very much as a path. Unfortunately right now the path doesn't look very good. But I think if our error bands on forecast over the next three months are big. So there is extraordinary uncertainty at the moment, but I think by just focusing on the path of production, thinking about policy and thinking about the flow of the data, you can at least give people who are investors, some clarity on what they're going through and how to frame it.

Beckworth: So James, to summarize, and I may oversimplify it here, but the V-shape is speaking really to the supply shock caused by the Coronavirus, in terms of disrupting global supply chains. Is that fair?

Sweeney: Well, I think the February part of it, I think as we get into March we're going to have more of a kind of a shock to investment in durable goods consumption.

Beckworth: If we have a pure V-shaped recession, that's actually good news in my mind, as opposed to maybe an L-shaped or something that's a little more pronounced. And what you're saying, I think is that if the demand spillover effects become more pronounced, if the uncertainty and all the other problems continue to grow and nature takes a longer course than we thought, it may not be a V-shape.

Sweeney: Yeah. And again, when we look at these industrial production slumps, so we had one in '11, '12 associated with the Euro crisis. We had one in late '14 until early '16, associated with dollar strength, oil weakness, big slump in mining and energy capex globally and sluggish investment in China. And we had another one from really mid '18 until the end of last year, associated with the trade war and auto weakness. And now you've added a gigantic slump right where you were maybe in the first innings of recovering from that trade war problem. But what's interesting about all those slumps that I just laid out, I mean they all lead to monetary policies and they all lead to recession fears. None of them have led to a rising unemployment rate.

Sweeney: And one of my favorite charts is showing people global industrial production growth through the years and all of the things that consistently happen in financial markets when manufacturing slumps. And then you just simply show the US unemployment rate and you show the same periods and you say, "Remember in '11, '12 and '15, early '16 and September, 2019 when everyone was saying the US recession is about to hit and you look at the labor data and it's almost as though nothing happened."

Sweeney: So these IP slumps don't always do that. When you're talking L-shaped, I think you're activating a deeper, broader, more persistent distress in the labor market, which does a lot more damage than just the more volatile goods sector. And that's the real question. The real question is, is the unemployment rate going to be trending sharply up over the next 12 months? In which case we can talk about zero interest rates across the curve and massive buying of securities and all sorts of creative policy responses. But I think if we can get this contagion under control by the end of Q2 and you can get a manufacturing rebound by the end of the year, big if's there, I don't really expect to see a very large move in unemployment. We do expect some weakness.

Sweeney: Now we're waiting for initial jobless claims to finally rise a little bit, suggesting that there's some weakness in the labor market, haven't seen it so far, but I think weaker payrolls, growth, higher initial claims and something of a move in unemployment, seems probable now through the remainder of the year. But the difference between a V-shaped manufacturing, heavy cyclical type slump that's really tied to the actual path of the virus, versus activating a persistent new path toward higher unemployment, is a vast difference. And that's really the first question. And I would say that our assumption is that we don't get that, that maybe it goes a little higher, unemployment, but we don't see it really changing things. And you spoke about inflation earlier, to me, if you had that, if you had unemployment in the US moving up to six, 7%, that's when you're worried about really jarring inflation away from that pretty steady moving average it's been within 30 basis points of, for most of the past 20 years. But as of now, this isn't our expectation that we're going to have that problem.

Beckworth: Yes, and you raise the issue of interest rates go into the zero lower bound or to the effective lower bound. And we've seen the 10 year Treasury drop below 1%, it's come up a little bit, even the 30 year dropdown down briefly below one. And it seems like this shock has really accelerated the downward march of Treasury yields. So we had a previous guest on the show named Paul Schmelzing, from the Bank of England and he has a paper on the 500 year decline of safe asset yields across the world. It's really fascinating.

Sweeney:  Yeah, I've seen it, I've seen it.

Beckworth: Yeah. And so the way I look at this current crisis is just expediting that journey down to the effective lower bound. And I guess my question to you is, do you think the change we've seen in Treasury yields, is that going to be a permanent ratcheting down? So for example in 2008, they failed, they didn't come back up, could this be a similar situation or if we have that V-shaped best case scenario, would you expect Treasury yields to go back up a little bit higher?

Sweeney:  I think if unemployment doesn't rise sharply, then near zero interest rates in the United States are unsustainable. And even what we're seeing right now is a huge pickup in refinancing of mortgages, as 30 year mortgage rates get down below 3%. I mean if you look at the last two recessions in 2001 and 2008, consumption had a very significant boost from the cash flow effects of falling energy prices and falling mortgage rates. And one of my favorite observations about '08, is that if you look at inflation adjusted retail sales in the US, they were much worse from Q4 '07 until mid '08, than they were in the actual financial crisis after August, September, 2008.

Sweeney: And what happened was that in early '08, you had an oil price bubble and interest rates were a bit higher, were higher and households were suffering from falling house prices and all that and the recession had begun. Then you get into August, September, '08, Fannie, Freddie, Lehman happens, the oil bubble had burst, oil prices charged down, long-term interest rates charged down, real retail sales, which had fallen by something like 6%, 7%, huge drop from December to August, started to go sideways after August.

Sweeney: So sideways is not great, but sideways is very different from straight down. So having lower oil prices and lower mortgage rates actually stabilize the consumer in the very period where the labor market was imploding because 90% of people participating in the labor market still had their jobs and were getting an added cash flow boost from falling mortgage rates and falling energy. So now we have falling mortgage rates and falling energy again. I'm not sure the outlook for consumption beyond the immediate contagion, stay indoors and don't go on an airplane shock, beyond that, I'm not sure the outlook for consumption is that bad because the household cash flow and balance sheet situation seems much better than it has been. So that's why I'm not counting on L-shaped and why I think in an economy where nominal GDP has trended at 4% for the past 10 years, I don't think zero interest rates make much sense. And where inflation has again, been close to the same number for the past 10 years.

Beckworth: Well we're fortunate that we did come into this situation with a very healthy economy, as you mentioned, nominal GDP growth being pretty solid, unemployment at all-time low. So we came in in the right condition, it's like a healthy person encountering some kind of shock to their system, it's better to be healthy than to be sick coming into it. In the time we have left, James, I do wonder from your perspective on Wall Street, you're in the trenches, you see the market's perspective. What advice would you give based on that, to policymakers, whether it's Congress and Treasury or the Federal Reserve? As we go through these next few weeks try to navigate the best policy responses, what do you see is the best response at this point?

Suggested Policy Response

Sweeney: Well, I think you have to be sensitive to the institutions when you're giving policy responses. So asking for some kind of policy response, which is unrealistic in the context of today's politics, is not necessarily helpful. The reality is that you need to get a fiscal stimulus through Congress. That's going to be tough. It's easier for the Fed to act and to act quickly and so the Fed is acting. I'm not sure that if we get, the market is priced for nearly 75 basis points in cuts last week, having done 50 at an emergency meeting last week. So this is just gigantic monetary stimulus, which I don't think hurts, but it's not the ideal policy response to this crisis. I think we need fiscal measures, which will help people pay their healthcare bills. I think the virus is the problem. I think you need people not to be avoiding a doctor's trip if they think they have the Coronavirus because they don't want to pay a copay.

The reality is that you need to get a fiscal stimulus through Congress. That's going to be tough. It's easier for the Fed to act and to act quickly and so the Fed is acting

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Sweeney: So I think the first thing you need to do is to make sure that these tests are available for everyone who needs one and that household's ability to pay some healthcare bills if this virus continues to spread, is backstopped by government support. So I think that's the first thing. And then hourly workers that see their hours decline or lose jobs, unemployment insurance is going to help with some of that, but I think you can think of ways of augmenting that. I think you can think of ways of incentivizing companies to hold onto some workers. I think given the tightness in the labor market, some firms may even be reluctant to lose workers in the next stage of this, which is a very good thing.

Sweeney: And you may have some industries with severe stress and they are, there's airlines. And so I think targeted measures at the actual problem make sense. The lower Fed rates are a broad macro stimulus. I'm not sure if fiscal broad macro stimulus would be as effective as something that could actually target to contagion. So that would be my view. Worry about the actual problem, which is that there's people saying that this can infect a very large percentage of the population. I think you throw everything at defeating that right now.

Beckworth: Okay. Well with that, our time is up. Our guest today has been James Sweeney. James, thanks so much for coming on the show.

Sweeney: Thank you very much. It's been really enjoyable.

Photo by Bryan R Smith

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