When the economy hits a rough patch, the government typically responds with stimulus or actions meant to jumpstart economic activity. There are two main ways the government does this: with monetary policy and fiscal policy.
It can be a little bit confusing because the words monetary and fiscal sound similar. Both influence the economy, but they do it in different ways. Understanding the difference between monetary and fiscal policy and how each works can help you understand whats happening in the economy, and how policy changes might affect your investments.
So first, Monetary policy is set by the Federal Reserve, the U.S. central bank. The Fed is responsible for pursuing price stability, maximum employment, and stable economic growth. To do this, the Fed has a few tools to adjust whats called the money supply, the total amount of money available at any given time.
When there is an economic crisis, the Fed does things like lower the federal funds rate, the rate banks use when they lend to one another. This typically pushes interest rates lower overall, which impacts demand for loans and the willingness of bankers to lend.
This is the main source of economic stimulation from monetary policy. Now lets get fiscal. Fiscal policy is set by Congress and the White House and is usually financed by the Treasury. It deals with taxation and government spending.
In difficult economic times, Congress and the president will often lower taxes with the hope that people and businesses will spend the extra money, stimulating the economy. At the same time, Congress and the president commonly increase spending on government projects like infrastructure and defense to help keep businesses working and citizens employed until the economy recovers. The government may even provide direct payments to businesses and individuals.
Think of it like this: Monetary policy works behind the scenes to stabilize financial conditions while fiscal policy works directly to advance a nations economy.
During an economic crisis, the government typically uses monetary and fiscal policy in tandem to prevent lasting damage to the economy, which could lead to a prolonged recession or even a depression.
The government response to the COVID-19 crisis is a good case study of how monetary and fiscal policy work together. Public safety measures to slow the spread of the virus caused economic activity to grind nearly to a halt. In response, the Fed adjusted monetary policy by dropping the federal funds rate to zero to keep borrowing costs low. It also used a tool called quantitative easing, or QE. This involves buying assets in order to keep money moving and avoid a financial system collapse. The monetary stimulus was accompanied by fiscal stimulus.
In March 2020, Congress passed the CARES Act, a $2.2 trillion bill that increased unemployment benefits, provided emergency loans and grants to businesses, and sent stimulus checks to millions of Americans. Congress passed an additional round of stimulus payments in December.
As of early 2021, economists and politicians were calling for more fiscal stimulus. Unemployment remained high and GDP had a hard time recovering fully, and future rounds of fiscal stimulus look likely with the new administration and Congress.
So what kind of impact do monetary and fiscal stimulus have on investments? Youll notice I havent mentioned the stock market much yet. Thats because these policies arent directed at the stock market; instead, they focus on the economy as a whole. And remember, the stock market is not the economy. However, expansionary fiscal policy can lead to higher demand for goods and services, which often leads to boosts in stock prices, though thas not always the case.
Similarly, improvements in overall financial conditions set by monetary policy can increase the money supply and push down interest rates and borrowing costs. This is good news for large companies that make up a majority of the big stock indices. Most major companies carry large amounts of debt, so companies could refinance or take on new debt with lower interest rates, a big boon for big business. Bottom lines get a quick lift, boosting profits. Lower interest rates also push investors toward stocks as lower rates mean lower returns on Treasuries. Look at 2020. After an initial downturn as the coronavirus took its toll on the economy, stocks soared to new all-time highs even while the overall economy had trouble stopping the bleeding and offices remained closed across the country.
Continued accommodative monetary policy and additional rounds of fiscal stimulus could drive stocks higher, but of course, there is no guarantee. One potential risk of monetary and fiscal stimulus is increased inflation, which is the rising cost of goods and services.
Some economists warn that too large of an influx of money into the economy can could destabilize financial markets and the price of the dollar It could also mean larger government deficits, which could lead to future tax increases for both individuals and businesses.
Higher business taxes could depress corporate revenues, negatively impacting portfolios. On the flip side, many economists now argue the $787 billion stimulus package President Obama passed in 2008 to help with the great recession wasnt enough to spur a strong recovery.
It can be difficult to predict the actual impact of government stimulus. In the end, monetary and fiscal policy are different things with a similar goal: economic stability. Keeping an eye on the different ways the government responds to economic crises and their impact on financial markets can help you better prepare your portfolio for the future.
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