Inefficient COVID-19 Relief Unlikely To Stop V Shaped Recovery

The US administration’s initial policy response to COVID-19 has provided the majority of workers with replacement income larger than their previous compensation. As a result, the labor market recovery is likely to be delayed. Nevertheless, I am still expecting a V shaped recovery as policies are becoming more efficient and as the administration faces few limits on deficit spending.

In most countries, the policy response to the coronavirus has included wage or employment subsidies or income support for laid-off workers. These measures have been anchored to the median wage, that is typically lower than the average wage, because of the right skew of income distribution.

In the US by contrast, COVID-19 relief measures have targeted 100% of the mean wage through a weekly $600 weekly benefit. As a result, estimates show that the median income replacement ratio across the US wage distribution is 138%, that the ratio is above 100% for 68% of workers, and above 200% for workers in the bottom 20% of the income distribution.

These high replacements ratios have already started to impact labor participation and unemployment. The Fed May Beige Book noted that “Contacts cited challenges in bringing employees back to work, including workers’ health concerns, limited access to childcare, and generous unemployment insurance benefits.”  Until the $600 payment scheme ends therefore, initial unemployment claims and unemployment rates are likely to remain on a U shaped recovery path.

Nevertheless, I still see a V-shaped scenario more likely than a U-shaped one for 3 reasons. First, the $600 payment expires at the end of July and the administration is looking for a replacement that addresses the adverse incentives.  A temporary $450 a week back to work bonus is under consideration that would strengthen the incentive to work.  Nevertheless, for the unemployed that cannot find work, some alternative to the $600 would have to be found, with a replacement ratio closer to 100% to support stronger labor participation.

Another measure getting bi-partisan support is an expansion of the $55 bn employee retention tax credit, 50% of up to $10,000 in wages paid by employers hit by COVID-19.  There is bipartisan support to expand the scheme to cover a larger share of wages and make it available to all employers, against currently SMEs only.  The scheme would support employment directly without creating disincentives to work.

Second, the administration is better targeting its coronavirus relief across the board for instance by restructuring the Paycheck Protection Program (PPP).  The PPP provides SMEs with low cost loans guaranteed by the Small Business Administration that get forgiven if employees are kept on the payroll.  The first round of the PPP, $350 bn, opened on April 3^rd and was exhausted on April 16^th. Disbursement of the second round, $310 bn has been much slower: it opened on April 28^th and as of May 23^rd only $160 bn had been disbursed.

The loss of interest reflects factors including state lockdowns that prevent business re-openings, and inefficiencies in loan terms and forgiveness, as well as employees reluctance to come back to work at their previous compensation levels. A bi-partisan group in Congress is looking at changes in the conditions attached to the PPP that could generate greater demand. Better PPP and unemployment insurance design would be mutually reinforcing in supporting a faster recovery.

More broadly, the administration is rationalizing its policy response.  Its initial response reflected a lack of preparedness as well as uncertainty surrounding COVID-19 and its potential economic impact.  The uncertainty has somewhat dissipated and a better understanding of life under COVID-19 is emerging, that will allow better designed policy support.

Third, the administration has the option of offsetting the adverse incentives created by its relief package with more fiscal pump priming, supported by Fed bond purchases. The slower labor market recovery for instance could see Congress vote another round of cash payments to households, following the $300 bn already included in the Cares Act. And while Congress is split, it would be difficult for the Democrats to stand in the way of further support to families, though of course there will be intense negotiations on the nature of the support. An agreement may not be reached until close to the expiration of the $600 payment, at the end of July, as the threat of a fiscal cliff could be needed to bring the parties together.

Markets seem unlikely to stand in the way of the administration deficit spending either. So far they have absorbed the very large increase in issuance without much impact on rates. Should this change and Treasury issuance lead to a tightening of financial conditions, Fed intervention would be very likely. Fed asset purchases have slowed since end-April and there is ample scope for stepped up balance sheet expansion.