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How is the Coronavirus putting countries at risk of recession?

The OECD has warned that global economic growth could be halved and slow to below 2.5%, which is widely considered to be recessionary. For countries like the UK and those in Europe, growth has been stagnant or tepid, so a “shock” like the coronavirus increases the risk of a recession. Since the coronavirus is a “supply shock” that affects, among others, supply chains and global value chains, it poses a challenge to monetary policy. It is hard for central banks because such shocks lead economists to consider a policy response that seems counter-intuitive. Fiscal policy thus has a greater role to play.

The best examples of supply shocks are the 1970s oil price shocks. That was the unenviable decade of “stagflation” when there was both high inflation and high unemployment along with weak growth. The dramatic rise in oil prices fed through into higher energy prices and input costs, which generated high rates of inflation. The usual response of raising interest rates to control inflation would worsen the economy.

The coronavirus is disrupting production and supply chains which could raise input costs and eventually prices. As firms will likely run down inventories first, a lot depends on the duration of the virus. Brexit could have raised input costs through trade disruptions. That was why the some at the Bank of England(BOE) referred to a potential supply shock during the fraught moments in the years since the 2006 EU referendum.

Should the current economic situation worsen, many would expect the BOE to cut rates. And the Bank would consider it, as it is at present, if it thought there was a negative shock to demand by consumers and firms. By cutting rates, it would support demand but also boost prices and potentially contribute to inflationary pressures at a time when the shocks to supply chains is already leading to expected shortages and potentially higher prices.

It is not straightforward to determine the nature of a shock. Supply and demand effects are likely both present and are intertwined. For instance, the coronavirus has had not only a negative impact on supply side of the economy, but it clearly also affects demand. Consumers in Asia and latterly parts of Europe have been affected as travel has been curtailed. In badly affected cities, there are restrictions to control the spread of the coronavirus. So, a supply shock also negatively affects demand.

The BOE has often “looked through” imported inflation. It wouldn’t be sensible to change interest rates to address fluctuations generated by volatile global conditions. But if the coronavirus ends up causing significant real supply chain disruptions as a supply shock, then we could be in for a period of inflation paired with anaemia growth. Such a supply shock would pose a challenge for monetary policy.

But, a central bank could ease credit conditions as well as lower the cost of borrowing. That would help firms with cashflow problems which could result from supply chain disruptions and also lower customer demand. That is unlikely to generate much inflation but could help millions of particularly small businesses weather such an unexpected shock.

But that might not be enough to prevent a stagnant economy from tipping into recession. It leads to the role that fiscal policy could play.

In a similar vein, supportive tax measures, such as on business rates or VAT, could help businesses get through a period of disruption on both the supply and demand sides. Such measures would help. But if the coronavirus lasts a significant period of time or is seasonal, then there could be severe or recurring business impact during the course of 2020.

Calibrating the amount of fiscal stimulus needed to avoid recession is always challenging, but more so under these uncertain conditions.

It is also well understood that fiscal policy requires more discretionary policy choices and can take some time to implement. That puts more pressure on the Chancellor to get it right next week. Discovering that not enough was done would mean another round of fiscal measures at a later point, which might be too late to head off a downturn.

The Chancellor does have a second Budget planned in the autumn so there is a checkpoint for more fiscal policy. Still, with the UK economy stagnant in the last three months of 2019 and a weakened global economy in the first quarter of 2020, Britain faces a challenging few upcoming months.

Getting fiscal and monetary policy calls right may well make the difference between a recession or not.

By Professor Linda Yueh, Visiting Professor at LSE IDEAS