Monetary and fiscal policies have a big impact on investors and non-investors alike, but few understand what they are. These policies are becoming an increasingly large part of our lives, as central banks push for the largest monetary policy actions in history while governments embark on huge fiscal projects.
These big forces have the potential to be the driving factor in what moves markets for years to come. If you’re an investor and don’t understand the difference between monetary and fiscal policy, buckle up as we dig deep into the two.
What Is Monetary Policy?
The simplest definition of monetary policy is any policy decision undertaken by the central bank of a country, such as the Federal Reserve. The last two decades have seen an unprecedented amount of monetary policy decisions undertaken by central banks around the world.
Most monetary policies go hand in hand with a central bank’s mandate: To control inflation and maximize employment. (Inflation hasn’t been an issue in decades and in many places around the world, the big fear is deflation.) Maximum employment is part of a robust and growing economy; as a result, central banks employ policies that attempt to grow the economy.
Central banks generally have the same tools to enact monetary policies:
- Interest Rates
- Reserve Requirements
- Other Measures
1. Interest Rates
The monetary policy decision that has been talked about most since the great financial crisis is the Fed’s ability to change interest rates. Around the world, central banks in OECD nations have set their interest rates to practically zero for over a decade.
The interest rate we’re discussing here is the federal funds rate. This sets the interest rate on overnight lending of excess reserves between commercial banks. This rate acts as an anchor point, impacting the interest rates on everything from government bonds to mortgages and credit card debt.
When rates are low, spending is encouraged. Debt is cheap and financing is generally plentiful. Likewise, when rates are higher, saving is encouraged. Not just by the avoidance of now-expensive debt, but also because savings accounts and bonds provide attractive returns.
Interest rate monetary policy is the Federal Reserve’s most powerful tool. And it’s the one that it has relied on most throughout its history.
2. Reserve Requirements
Used in tandem with interest rate policy decisions is the Federal Reserve’s reserve requirements policy.
The Federal Reserve sets how much cash banks must have on hand at any given time. This is to prevent the danger of banks collapsing during a crisis. Although setting a high reserve requirement can also dampen growth.
Banks have a finite number of dollars that they can choose to lend out. When banks keep a higher percentage on their balance sheet, less is lent out. Credit is one of the big drivers of economic growth in a modern economy and reserve requirements directly impact credit.
Reserve requirements and interest rates are often used together. It creates a powerful one-two punch: low-interest rates incentivize people to take on debt and spend, while lower reserve requirements incentivize banks to lend out more money.
3. Other Measures
One part of the Federal Reserve’s policies that would have been unthinkable a few decades ago is its growing toolkit of “extraordinary” measures. This happened during the great financial crisis. In order to stop the economy from plunging into a deep depression, the Fed used a number of controversial monetary policy actions.
The most famous which lasted for years after the crisis is quantitative easing (QE). QE is when a central bank directly purchases an asset in order to increase the money supply in an economy.
The Federal Reserve chose to engage in quantitative easing during the great financial crisis after attempting to move interest rates to zero and seeing that there was little effect. With QE, they directly bought U.S. treasury bonds to increase the amount of money throughout the economy.
The Fed further expanded its buying to the then-defaulting mortgage backed-securities from banks. This alleviated the risks to the commercial banks while also injecting them with needed liquidity to further lend out to the economy.
Other countries’ central banks have taken the policy of QE even further. The Bank of Japan, for instance, began buying private debt and even Japanese ETFs in order to encourage growth.
What Is Fiscal Policy?
Fiscal policy is any decision by a country’s government to steer the economy towards a specific goal. There’s been much more interest in fiscal policy following the coronavirus pandemic, which left countries around the world in emergency situations.
The idea of a government policy to specifically grow the economy is relatively new. Until the Great Depression, governments around the world did not factor in economic growth in their policy actions. Instead, they took a backseat approach to the economy.
Fiscal policies are now a regular part of the government’s toolkit to maximize employment and stimulate growth. Fiscal policy spending took a backseat in the wake of the 2008 financial crisis. Instead, OECD countries across the world took to the policy of austerity to strengthen the financial health of their governments.
Fiscal policy decisions revolve around a government changing tax rates and directly spending money on different parts of the economy. Here are some of the tools at a government’s disposal:
1. Tax Rates
Benjamin Franklin once said the only two guarantees in life are death and taxes. It’s not surprising to hear that changes in taxation can have big effects on the economy.
The government runs on its tax revenues, with any shortfalls being made up through selling government bonds which act as IOUs. This means that the government can theoretically minimize its tax revenues by lowering tax rates and still function through the use of bonds.
Many modern large economies do this because taxation has a very direct impact on spending in an economy — and spending is the lifeblood of a healthy economy.
Think of it this way: If you pay 20% of every dollar of your income in the form of different taxes and suddenly the rate is lowered to 15%, you now take home $0.85 instead of $0.80. That $0.05 doesn’t seem too large but multiplied by hundreds of millions of people and that’s a lot of extra cash.
Subsidies act in a very similar way and are essentially anti-taxes. The government is willing to cover the cost of something for the people, in order to free up disposable income.
2. Direct Spending
The other major tool a government has to impact the economy is to spend directly from its own coffers. The most common examples of this are large infrastructure projects. Through these projects, which are often far too costly for any individual business to take on, the government creates a large number of jobs. The projects themselves also often serve to increase economic utility, such as bridges to make transport more efficient.
Consider the U.S. highway construction project, which took many years and thousands of workers to complete. The workers weren’t only menial laborers either; there were many professionals involved in the planning and execution of the projects. Supplier businesses also benefited from the project. Finally, the highways allowed a much more efficient transport of goods across the countries leading to better economic output.
3. Extraordinary Fiscal Policy
Today we are seeing the dawn of never-before-seen fiscal policy in order to combat the economic damage done by the pandemic. This includes direct stimulus checks, a fiscal policy decision that’s been theorized and debated for decades.
While governments have spent directly into an economy before, they often avoid paying people directly, instead preferring trickle-down benefits to citizens. This all changed recently when the U.S. government decided to send all citizens (with exceptions) a stimulus check.
This really ties the government’s traditional tools of direct spending and subsidies, as the government is directly sending dollars from its own coffers in order to subsidize the cost of living for its citizens. This policy decision also opens the door for further conversations on more radical policies such as universal basic income.
Monetary Policy vs. Fiscal Policy
While we have mainly discussed specific policy choices to stimulate more growth, both policy types can be used for the opposite means. This is done to keep an economy from overheating, leading to inflation or asset bubbles.
That leads us to the three goals fiscal and monetary policy share: stimulating economic growth, maximizing employment, and minimizing inflation. Note that the goal of minimal inflation and maximal employment often conflict, leading to a delicate balancing act.
The Differences Between Monetary Policy and Fiscal Policy
- The most important difference between monetary policy and fiscal policy is the government bodies responsible for them. The Federal Reserve, despite working closely with the U.S. government, is an independent body. This means that it may enact monetary policies that are stimulatory for the economy, while the U.S. government enacts measures that are contractionary, such as raising tax rates.
- These policies don’t necessarily have to lean in the same direction and are another part of that delicate balancing act.
- The effects of both policy decisions are different. Fiscal policies are often very tangible in nature, and seen or felt on the ground by the average person. Think about direct stimulus payments or a new underground rail system.
- Monetary policy deals with things that are more abstract. Interest rates do affect mortgages, but not everyone is buying a house. And interest rates have remained around zero for over a decade. Monetary policies often have much larger second and third-order effects.
How Do Fiscal and Monetary Policies Impact the Economy?
Since the Great Depression, fiscal policy has been a larger part of the economy. Governments began taking an active part in the shaping of the economy rather than allow the “invisible hand” to work on its own.
We already mentioned the tangible benefits many infrastructure projects leave for decades. The same is true for monetary policies. During the 1970s stagflationary period, it was the extreme monetary policy decisions taken by Paul Volker that finally tamed inflation and allowed America to get back on track to enjoy the booming decade of the ’80s.
Volker did this by raising rates far higher than anyone expected, sending shocks throughout the economy and causing much short-term pain. This is also a perfect example of how monetary and fiscal policy can often be at odds. It is clear that the government wouldn’t pursue policies meant to harm the financial well-being of citizens, but that is what Volker did for the greater long-term good.
How Do Fiscal and Monetary Policies Impact You as an Investor?
An investor who knows the different policy tools and understands the long-term impacts of such decisions is already at an advantage. This allows investors to reposition themselves accordingly.
- Investors who understood the magnitude of the decision to pursue quantitative easing during the lows of the 2008 bear market knew that QE was likely to signal a turning point and lead to a significant recovery.
- Most recently the government announced extraordinary fiscal stimulus in the form of direct checks. This announcement signaled the bottom of the sharp crash, and markets began rising shortly after on renewed confidence.
- Lastly, it is also important to understand the possible negative impacts of policy decisions. A dramatic rise in tax rates could shake a wobbly economy right into a recession. And significant amounts of monetary policy could lead to inflation spiking. Investors who can see these red flags coming will stand a much better chance in the long term.
The Benefits of Following Policy Decisions
In today’s markets, fiscal and monetary policy can have significant impacts on the stock market. It’s foolish for an investor to not pay attention to policies that can have such an effect on their portfolios.
Understanding the significance of these policy decisions should allow you to invest more confidently and avoid painful mistakes.