In a speech published the Fed’s vice chair Randy Quarles, which comes one week before the results of the Fed’s annual stress tests are revealed (and which some speculate will impose limits on how many dividends the banks can pay out), the Fed’s top banking regulator announced that for the first time, the Fed will also add a coronavirus pandemic stress test, one which assess for an optimistic V-shaped recovery, ii) for a slower, U-shaped recovery (in which only a small share of lost output and employment is regained in 2020), which also sounds optimistic, and iii) a W-shaped double dip recession which accounts for a second wave in infections.
From the speech:
Based on past experience and our standing policies, our February scenario assumed stress in corporate debt and real estate markets, among other details, and an increase in unemployment considerably larger than occurred in the Great Recession. Compared to what we are now experiencing, this scenario was less severe than the unprecedented drop in employment and output in the second quarter of 2020 but more severe than the extent of stress we’re seeing in debt markets. It also didn’t include the unprecedented extent of fiscal stimulus.
But the larger issue is the unprecedented uncertainty about the course of the COVID event and the economy. The range of plausible forecasts is high and continues to shift. We don’t know about the pace of reopening, how consumers will behave, or the prospects for a new round of containment. There’s probably never been more uncertainty about the economic outlook. Although our policies on stress testing emphasize the value of not increasing capital requirements under stress and thus exacerbating a downturn, our first priority must be—and is—to understand the implications of quite plausible downside scenarios from our current position for bank capital.
In light of that uncertainty, our sensitivity analysis considers three distinct downside risk paths for the economy:
- first, a rapid V-shaped recovery that regains much of the output and employment lost by the end of this year;
- second, a slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020;
- and third, a W-shaped double dip recession with a short-lived recovery followed by a severe drop in activity later this year due to a second wave of containment measures.
In kneejerk response, after spiking earlier, financial legged modestly in the red as the Fed is now actively considering a double dip recession, something it wouldn’t be doing if it was not on the table.