Wanted: Policy Action

A decisive and coordinated policy action is key to combat the economic fallout from the coronavirus outbreak. Mike explains why.

Fears about the coronavirus and its hit to the economy have rattled stocks and sent government bond yields to record lows. Even a surprise 0.5% interest rate cut by the Federal Reserve did little to calm the jitters. The material uncertainties related to the outbreak is giving public health officials a strong incentive to act aggressively to mitigate its human toll. But these public health measures, though temporary in nature, slow economic activity, sometimes drastically. We believe this will eventually set the scene for a strong rebound in economic activity, but a decisive policy response is needed to safeguard economic fundamentals.

Policy can target three things in the face of this shock: prevent a sustained tightening of financial conditions; help stave off cash flow shocks that would threaten to shutter otherwise sound businesses; and support individuals whose incomes are eroded by the disruptions. We see a need for a decisive and pre-emptive policy response across these dimensions. The remaining space for traditional monetary policy tools such as rate cuts is limited, with interest rates near all-time lows. Simply using up that space – especially without coordination with fiscal policy – could quickly draw attention to the empty toolbox and backfire. The Federal Reserve cut interest rates last week, outside a policy meeting for the first time since the 2008 financial crisis. That rate cut failed to stabilize markets, which are now pricing in an even steeper drop in the Fed’s policy rates – as the chart shows.

The only way to address the diminished monetary policy toolkit is to add more lines of defense, such as bringing in fiscal policy explicitly as part of the emergency response. This echoes our view that monetary-fiscal coordination is critical in dealing with the next downturn. We are seeing early signs of a response to the current shock. Fiscal policy is the space to watch. Europe’s finance ministers appear prepared to launch fiscal measures. U.S. officials are likely to take up greater fiscal action if events warrant it – beyond the $8.3 billion in emergency spending approved last week – even in an election year with a divided government.