When the economy hits rough patch, the government typically respond with stimulus or actions meant to jump start economic activity. There are two main ways the government does this; with monetary policy and fiscal policy. They can be 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 the monetary and fiscal  policy and how each works can help you understand what is happening in the economy and how policy changes might affect your investments. So first, monetary policy is set by the federal reserve, the US 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, the money printer goes burr…. in more controlling how easy or difficult it is for people in business to borrow money.

When there is economic crisis, the fed does things like lower the federal funds rate, the rates banks use when they lend to one another. This typically pushes interest rate lower overall which impacts the demand for loans and the willingness for the bankers to lend. This is the main source of economic stimulation for the monetary policy. Now let’s get fiscal. The fiscal policy is set by the congress and the white house and it 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 in businesses will spend the extra money stimulating the economy. At the same time, the 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 physical 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 Covid-19 crisis is a good case study of how monetary and fiscal policy worked 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 fund’s rate to zero to keep the borrowing costs low. It also used the 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, the congress passed the CARES act, a 2.2T dollar bill that included 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. In future rounds of fiscal stimulus look likely with the new administration and congress. So what kind of impact do the monetary and fiscal stimulus have on investments? You’ll Notice that 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 can refinance, take on new debt with lower interest rates, a big boon for big businesses. Bottom line gets a quick lift, boosting profits. Lower interest rates also push investors towards stocks. Lower rate, lower return on treasuries. 

Look at 2020, after an initial downturn, as the corona virus took a 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 warned that too large an influx of money into the economy 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 individuals and businesses. Higher business taxes could depress corporate revenue, negatively impacting portfolio. On the flip side, many economists now argue that the 787 Billion dollar 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 different ways the government responds to economic crisis and their impact on financial markets can help you better prepare your portfolio for the future. 

Courtesy: TD Ameritrade