In recent years, the Federal Reserve has captured significant attention, and understandably so. Investors are closely watching the central bank’s monetary policy, relying on it to combat inflation and guide the bustling U.S. economy to a gentle landing.
However, as the fall presidential election draws near, another player in the economic arena is poised to step into the limelight: fiscal policy, steered by the White House and Congress. The synergy between these two forces will shape the trajectory of both the economy and the markets in the coming months.
To grasp the significance of these dynamics, it’s essential to understand the nuances of fiscal and monetary policy. Fiscal policy pertains to how the government generates revenue and directs its spending to achieve specific outcomes.
On the other hand, monetary policy refers to the actions undertaken by the country’s monetary authority—in the case of the U.S., the Federal Reserve—to attain desired economic objectives. These objectives typically include maintaining a stable economy characterized by low unemployment and price stability, which constitute the core tenets of the Fed’s dual mandate.
Fiscal policy and monetary policy operate independently, though their effects intertwine. Each policy can fall into one of three categories: neutral, contractionary, or expansionary.
A neutral policy aims to maintain the current economic state without significant alterations.
A contractionary policy endeavors to curb economic activity, often in response to high inflation rates. This is achieved by implementing measures that reduce the circulation of money, thereby diminishing purchasing power and consequently lowering demand.
Given the U.S.’s reliance on consumer spending, its economy can be stimulated or slowed down by adjusting the accessibility of consumer goods and services.
Conversely, an expansionary policy seeks to invigorate the economy, either to alleviate unemployment or spur further growth. In this scenario, the objective is to boost the amount of money in circulation, thereby fostering increased demand for goods and services.
The overarching objective is straightforward, despite the complexity of the strategies employed: Foster conditions conducive to a healthy economy. This entails achieving moderate growth alongside stable prices while ensuring job opportunities for all willing participants in the workforce.
Such an environment facilitates informed decision-making among businesses and individuals regarding saving, spending, and investment, as stability breeds predictability.
Lawmakers Can Have Two Levers
The government possesses two primary tools—taxation and spending—to steer towards its intended objectives.
Suppose the U.S. government aims to bolster economic activity. In such a scenario, policymakers would implement an expansionary policy, facilitating increased money circulation within the economy.
Washington can opt to lower taxes, thereby augmenting disposable income for both consumers and businesses, which ideally translates into heightened expenditure on goods and services. Alternatively, it can escalate spending, injecting funds into the system. Combining both approaches is also feasible.
To execute the first strategy, the government can directly slash tax rates, augmenting citizens’ disposable income. Alternatively, it may indirectly authorize tax credits, which simultaneously decrease tax burdens while incentivizing specific types of spending.
For instance, introducing tax credits for electric vehicles or solar panel purchases encourages the transition away from fossil fuels.
Spending can manifest in various forms, including transfer payments (such as health benefits, welfare, and social security), expenditure on goods and services (like student loan repayments and defense spending), and infrastructure initiatives (such as the CHIPs Act, aimed at boosting semiconductor manufacturing in the U.S.).
Conversely, a contractionary policy adopts the opposite stance. To temper economic growth, the government seeks to diminish the money supply within the system, achievable through heightened taxation—thus curtailing individuals’ expenditure on goods and services.
This can occur directly, like increasing income tax rates, or indirectly, such as imposing “sin taxes” to discourage unhealthy habits, exemplified by hefty taxes on cigarettes in the U.S.
Alternatively, the government can scale back spending. For instance, reducing tax credits may dampen demand for specific goods or services.
The effectiveness of these policies hinges on the magnitude of alterations and their combination.
For instance, the government might increase both taxes and spending to attain a more neutral policy or to reshape the economy and redistribute wealth. Alternatively, it might lower taxes for certain earners while concurrently boosting spending in targeted sectors.
These decisions unfold within the realm of politics. Economic concerns may not always monopolize the agenda, underscoring the necessity for scrutinizing fiscal policy analysis, perhaps even more rigorously than monetary policy.
While an administration prioritizing spending cuts and tax hikes might be acting in the economy’s best interest by striving for a balanced budget, it could also prompt a desire for change among some voters. Ultimately, individual voters may prioritize personal finances over the government’s fiscal prudence.
The Three Tools Of Federal Reserve
While the Federal Reserve wields an array of instruments, its primary means of influencing the money supply in the economy center around three key mechanisms: the overnight interest rate (commonly known as the federal funds rate), open market operations (the buying and selling of securities), and adjustments to the reserve requirement imposed on banks.
Beginning with interest rates, the Fed can directly impact the overnight rate, which is the rate at which it lends money to commercial banks and serves as the benchmark for interbank lending.
When discussions arise about raising, lowering, or maintaining rates, they typically refer to the fed funds rate.
Increasing this rate diminishes the appetite for borrowing, thereby curtailing demand for goods and services typically acquired through borrowing. For instance, if banks face higher borrowing costs, they, in turn, raise the rates they charge borrowers. Since banks generate revenue from the spread between borrowing and lending rates, hiking the overnight rate constitutes a contractionary measure.
Conversely, lowering rates reduces borrowing costs for banks, fostering greater affordability for borrowers and stimulating demand for goods and services financed through loans.
The Fed can also directly influence the money supply through open market operations, historically accomplished via the purchase and sale of government bonds. To inject money into the system, the Fed purchases government bonds, thereby increasing government debt but infusing cash that can be deployed for economic stimulus initiatives.
Conversely, to withdraw money from circulation, the Fed can sell bonds, thereby reclaiming the cash used for purchases along with interest, or allow bonds to mature without replacement, gradually reducing the money supply.
Furthermore, these open market activities exert an indirect influence on longer-term interest rates. Given the inverse relationship between rates and bond prices, the Fed’s substantial purchasing power in the Treasury market can drive up bond prices and consequently lower longer-term interest rates.
This dynamic, while less direct than adjusting the overnight rate, significantly impacts longer-term financing, such as mortgages, making them more affordable and stimulating housing demand.
The third tool at the Fed’s disposal involves adjusting the reserve requirement imposed on banks, mandating a minimum capital threshold based on risk-weighted assets. A higher reserve requirement constrains the amount of money available for circulation within the economy.
For instance, if a bank holds $100 billion available for lending but faces a 10% reserve requirement, it can only lend around $90 billion. The Fed can tighten monetary conditions (contractionary) by raising the reserve requirement or loosen them (expansionary) by reducing it, thereby influencing the money supply.
It is important to understand how their actions interact with each other. As there are two entities with two possible policies (expansionary or contractionary), there are four potential policy combinations, not including a neutral stance.
1. When both fiscal and monetary policies are expansionary, the economy is flooded with money from various sources. This was seen in 2020 during the pandemic when the Fed lowered the overnight rate to zero and purchased securities, even those considered riskier than Treasuries.
At the same time, the government provided stimulus checks to individuals. As a result, excess cash flowed into the stock market.
2. On the other hand, when both fiscal and monetary policies are contractionary, the authorities are limiting economic growth. This could involve the Fed raising interest rates and selling securities, causing higher yields.
Meanwhile, the government may raise taxes and reduce spending, leading to less consumer spending.
3. A combination of expansionary fiscal policy and contractionary monetary policy is more complex. In this scenario, the Fed is tightening its monetary policy while the government is lowering taxes. This could have different effects on individuals depending on their financial situations.
For example, higher interest rates could make credit-based purchases more expensive, but lower taxes could provide increased after-tax income. The impact on corporations and stocks is also uncertain, as higher interest charges may be offset by increased consumer spending due to lower taxes or subsidies.
4. Similarly, when there is a contractionary fiscal policy and an expansionary monetary policy, the outcome is not clear-cut. With the Fed working to lower interest rates, it becomes cheaper to borrow money.
However, this could be offset by higher taxes, resulting in reduced after-tax income. Corporations may benefit from lower interest rates, but this could be countered by lower consumer spending.
What implications do these policies have on the stock market?
The key factor here is the balance between supply and demand. As we analyze the actions taken by fiscal and monetary authorities, we must consider their effects on both supply and demand in various areas.
How will it affect the demand for goods and services from consumers? Will there be changes in hiring? How will it influence the demand for capital and the cost of financing? Will the demand decrease or simply shift?
Are there any subsidies or sin taxes being implemented to alter consumer behavior? By addressing these questions, we can begin to understand how these policies may impact a company’s sales, earnings, and valuation multiples or discount rates.
For instance, let’s look at the demand for iPhones in light of these policies. If taxes are raised (fiscal tightening), it’s logical to assume that consumers will have less disposable income, which could lead to a decrease in sales.
However, if the Federal Reserve simultaneously maintains an expansionary policy and lowers interest rates, this could potentially offset the impact of higher taxes by making it more affordable for consumers to finance an iPhone purchase.
We might also see wireless providers offering subsidies to make the new iPhone more accessible. The performance of Apple, its sales and earnings, and the valuation placed on the company by investors will ultimately depend on how all of these factors balance out.
A company with a significant net cash position, for example, may benefit from higher rates as it will earn more interest on its cash holdings. On the other hand, businesses that rely heavily on debt financing may face challenges as the cost of borrowing increases in a high-interest environment.
However, these policies, no matter how well thought out, may not always have the intended consequences. For instance, the government could eliminate taxes, but if consumers choose to save their money rather than spend it, it would not stimulate the economy.
The majority of the US economy is driven by consumer spending, not savings. Therefore, if the tax cut does not lead to increased spending, it will not have the desired effect. This was evident in the banking industry in 2022.
Higher interest rates are typically beneficial for banks as they can charge higher interest on loans and increase their net interest margins. However, in this case, we saw that rates can rise too high. While there was an initial expansion in net margins, this was later offset by depositors withdrawing their funds and investing them in higher-yielding alternatives.
Higher rates were advantageous until they became detrimental. There may be expected outcomes for each policy and combination of policies, but in reality, fiscal and monetary policies can be highly creative and difficult to fully comprehend until after the fact.
