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 what’s 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 what’s called the “money supply,”
the total amount of money available at any given time.
It’s less “money printer go brr” and more
controlling how easy or difficult it is for people and businesses to borrow money.
When there’s 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 let’s 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 nation’s 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?
You’ll notice I haven’t mentioned the stock market much yet. That’s because these policies aren’t
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 that’s 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’s 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 wasn’t 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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