Fed officials have yet to sound a strong alarm. U.S. fundamentals remain quite good. But with additional time and consideration, we think the Fed will want to ease financial conditions and buffer the economic blow. A cut should come at the end of April. More may be needed if we slip into a more severe scenario.
Earlier this week, the World Health Organization said it would be premature to classify COVID-19 as a pandemic. But the risk of an economic pandemic is rising.
Chain Reactions
There has never been a better time than today to be a consumer. The assortment of goods available is broad, of high quality, and affordable. These gains have come from decades of process refinement, as producers root out inefficiencies and seek competitive advantages. But the systems that have served the global economy so well have now created systemic risks.
Just-in-time (JIT) manufacturing has been central to this evolution. Pioneered by Toyota, JIT seeks to integrate and optimize every touchpoint of an assembly process. Prior to Toyota’s innovations, auto factories could be thought of as simple production lines, with loads of raw materials going in one door and finished vehicles driving out the other side. The factory ordered whatever was needed to produce a vehicle and handled assembly on its own. Toyota was the first to integrate its suppliers into its processes, planning exactly which vehicles would be produced at set times. Its suppliers delivered only the inputs required and no excess, exactly when needed and no sooner. This formed the basis of supply chains, which have been broadly adopted in recent decades.
The advantages of this approach are clear and profitable. Its investment in planning allowed Toyota to lower its stocks of unfinished inventory and free up working capital. The careful coordination raised the cost of work stoppages from defects, requiring quality controls that led to more reliable finished products.
JIT manufacturing creates sensitive linkages between suppliers and buyers. Suppliers must be able to deliver to their customers on time, with no margin for error. While many industries initially worked in clusters, with manufacturers and their suppliers in close geographic proximity, supply chains have grown longer. As global shipping has become cheap and reliable, components can be built in any location that provides cost advantages and shipped worldwide. Final assembly is still happening just-in-time, but with inputs that have been shipped weeks in advance of production.
The benefits of JIT caught on across sectors, and China became a dominant provider. These enhancements brought gains in quality and costs that have benefitted both producers and consumers. But those efficiency gains created a new geographic risk. Placing final assembly in one region, with inputs dispersed among other nations, assumes those regions will remain productive and accessible. Recent developments suggest that such confidence was misplaced.
Modern manufacturers share a weakness: If a production line stops, carefully choreographed supply chains will choke. Quarantines and travel restrictions slowed the flow of workers and materials into China’s factories, a severe blow to a manufacturing-dependent economy. Estimates of China’s recovery are variable and uncertain. The country’s output is currently estimated to be at half its usual level, and it will take months to return to 100%.