Morgan Stanley
  • Research

The Fed Eyes the Coronavirus Toolkit

As the impact of the outbreak comes into view, U.S. policymakers have indicated that they will use all of the tools at their disposal. A coordinated fiscal and monetary response could be the answer.

The spread of the novel coronavirus, known formally as Covid-19, has disrupted economic activity and financial markets worldwide. Last week, the Fed responded with an emergency half-point interest rate cut, signaling a desire to preempt market disruptions that could amplify downside effects on the economy. 

Combining—or even coordinating—a fiscal and monetary policy response would not only provide a stronger buffer for the U.S. economy, but would likely also raise confidence in markets more than rate cuts alone.

As the impact of the outbreak hits the U.S. economy from a variety of angles—production and consumption, supply chain interruptions, tourism and others—policymakers have shown that they will use all of the tools at their disposal to mitigate the effects. Although emphasis will remain on the monetary response, raising confidence in markets could require a coordinated monetary and fiscal response.

Our Chief Global Economist, Chetan Ahya, has now formally adopted a base case scenario that assumes the coronavirus outbreak peaks in April/May, pushing down global GDP growth to 2.3% in the first half of the year, before recovering in the third quarter of 2020.

For the U.S., we have lowered our full-year 2020 growth forecast by 30 basis points, or 0.3 percentage point, to 1.5% for the year, with a low of 0.6% annualized growth in the second quarter. As a result, we now expect the Fed to follow last week’s half-point rate cut with another half-point rate cut at its March meeting, and a quarter-point rate cut at the April meeting. This would bring the Fed funds rate into a 0.25%-0.50% target range. 

Implications for U.S. Economic Activity

Since events are unfolding rapidly, with a high degree of uncertainty, our views at this stage depend on both the evolution of the outbreak and financial conditions. To analyze the effects of the coronavirus epidemic on the U.S. economy, our economics team has laid out a four-channel approach to modeling key impacts:

1.   Direct demand: Reduced production and consumption activity will weigh on demand for U.S. exports. Given that the virus has spread to more regions of the country, we are also including effects on domestic demand.

2.   Indirect supply chain effects: The sustained cuts to production in China and, potentially, elsewhere, could limit the supply of inputs to U.S. production, which would disrupt manufacturing activity.

3.   Tourism: As reduced spending from foreign tourists weighs on U.S. businesses.

4.   Financial conditions and sentiment: These reflect market reactions and the impacts on economic activity, as well as effects on consumer and business sentiment domestically. This channel has become increasingly more important against a backdrop of rising market volatility and a Fed that is easing monetary policy to "avoid a tightening of financial conditions."

Using this framework, we are building more significant disruptions to global and domestic activity into our baseline outlook because of compounding negative effects from all four of these channels. 

Export growth will likely soften as a result of reduced production activity and demand globally; although, this should be partially offset by lower import growth due to both weaker domestic demand and disrupted production activities in China and globally.

Consumer spending could also pull back, particularly in the second quarter, as consumer sentiment weakens, leading to a sharp reduction in discretionary spending. 

As a result, reduced discretionary spending could spill over into some service sector labor markets, such as leisure & hospitality or retail trade, resulting in temporarily reduced employment and hours, which would further weigh on consumption.

This could disrupt labor markets in the short term, primarily affecting hourly paid workers, who might get sent home due to disrupted business activities. This could temporarily boost the unemployment rate 30-50 basis points to between 3.9%-4.1%.

Monetary Tools at Work…

In response, the Fed’s toolkit will likely include a broad range of actions and facilities. On March 9th, the Fed reached for the low-hanging fruit to provide liquidity by increasing the size of the overnight repurchase-agreements operation—often called the repo market—from $100 billion to $175 billion.  The Fed could also restart quantitative easing, which is designed to get longer-term rates lower—inarguably not needed in today's environment—but as a signaling mechanism can nevertheless put a floor under market sentiment, all else equal.

The Fed has other facilities in its purview, like the Term Auction Facility. This policy program, first used during the 2007 subprime crisis, allows the Fed to receive a much broader range of collateral from depository institutions beyond just Treasuries or agency-backed mortgage-backed securities (MBS). These auctions would allow financial institutions to borrow funds at below the discount rate and address pressures in short-term funding markets.

Finally, recent Fed-speak suggests that policymakers are trying to think outside of the box. Boston Fed President Eric Rosengren recently floated the notion that the Fed might be able to purchase assets outside of Treasuries and agency MBS, if Congress allowed an amended Federal Reserve Act.

…Alongside Fiscal Tools

Fiscal tools could also be employed. To help mitigate the impact on small businesses, the Small Business Administration's (SBA) loan programs could be used to provide financing for hard-hit businesses and provide a buffer for the U.S. economy.

The SBA has two tools in particular to finance small businesses. Economic Injury Disaster Loans (EIDL) could become available once a disaster is formally declared. Another tool could guarantee bank loans to small businesses. After the 9-11 attacks of 2001, a separate facility was created for so-called STAR loans, which provided $75 million in Congressional funding that the SBA leveraged to guarantee nearly $5 billion in loans made through depository institutions to small businesses.

Combining—or even coordinating—a fiscal and monetary policy response would not only provide a stronger buffer for the U.S. economy, but would likely also raise confidence in markets more than rate cuts alone, and help to support more accommodative financial conditions as a result.

For Morgan Stanley Research on the impact of the coronavirus on the global economy, ask your Morgan Stanley representative or Financial Advisor for the full report, “Policy Near the Zero Lower Bound” (Mar 8, 2020). Plus, more Ideas from Morgan Stanley’s thought leaders.