Whether caused by natural market factors or an unforeseen catalyst, changes in the business cycle can create distress for American families. Unchecked growth can lead to runaway inflation which hinders your ability to buy the things you need. On the other hand, economic contractions can lead to job loss and significant hits to your investment portfolio.
The federal government and the Federal Reserve aim to mitigate extremes in the business cycle and promote a stable economy. They each have their own toolkit for achieving these goals – fiscal and monetary policy.
What is fiscal policy?
Fiscal policy includes action taken by the federal government to strengthen the economy in times of distress or curb inflation during times of prosperity. This type of economic policy works by targeting aggregate demand. In other words, it imposes changes that encourage people to spend more or less money depending on the policy goal. Most commonly, Congress implements fiscal policy through the federal budget or tax code.
Fiscal Policy Targeting Government Spending
The level of government spending is one way that Congress can influence demand and the economy. This type of fiscal policy can be implemented in several ways, depending on the current economic situation and the government’s goals.
During economic expansion, Congress may pull back on spending in overheated areas of the economy to decrease demand – called contractionary fiscal policy. However, this type of policy is rarely used. The last time it was implemented on a large scale was during the Clinton administration when President Clinton cut spending in several key areas to balance the budget.
Expansionary fiscal policy is much more common. This generally occurs during a recession and involves Congress spending more to increase demand. For example, during the COVID-19 pandemic and ensuing recession, the government spent over $4 trillion, including payments to individuals, enhanced unemployment benefits, and health care for those effected by the pandemic.
Fiscal Policy Targeting Taxation
In addition to adjusting the level of government spending, Congress can make changes to the tax code to achieve fiscal policy goals. This type of policy works by changing the amount of tax that families and businesses must pay – leaving them more or less money to spend on other products.
When the economy overheats, Congress might raise taxes to reduce the amount of money that people have to spend – and therefore reduce demand for goods and services. On the other hand, Congress may cut taxes during an economic contraction to stimulate spending.
Tax brackets are rarely altered to influence the economy during a particular market cycle because changes in the tax code are typically long-term, outlasting economic shifts. Instead, policy makers generally make changes to deductions or credits. For example, Congress paid advance tax rebates in response to the 2008 financial crisis. These temporary tax rebates lowered federal taxes by about 5% in 2008.
Fiscal Policy Through Automatic Stabilizers
Automatic stabilizers are built into the tax code and federal budget so that fiscal policy reacts to changes in the business cycle without legislative approval. One of these automatic stabilizers is the progressive tax code – which imposes a higher tax burden on people and businesses with higher income.
When economic output is high, incomes increase as do tax revenues. During these times, government spending tends to fall as fewer people need assistance.
When economic output is low, government spending tends to increase because more people require assistance from government programs. As incomes fall, the government also takes in less tax revenue.
What is monetary policy?
Whereas fiscal policy is implemented by the federal government, monetary policy is enacted by the Federal Reserve. It aims to influence the economy through interest rates and the money supply.
Monetary Policy Targeting Interest Rates
Interest rates influence the amount of money people and businesses can afford to borrow. Since many types of goods and services require financing, rates also influence the amount and types of products purchased.
During times of economic expansion, the Fed will raise interest rates to curb spending and the inflation that results from excessively high demand. Conversely, the Fed often lowers interest rates during a recession to encourage spending and bolster the economy.
However, it is important to note that the Fed doesn’t set interest rates for private loans. Instead, they adjust the Fed Funds Rate – the rate banks pay for short-term loans from other banks. The Fed Funds Rate influences other interest rates, like mortgages and personal loans, but markets are also influenced by other factors so there is still room for variation among lenders.
Monetary Policy Targeting the Money Supply
While interest rates take center stage in most monetary policy discussions, the Fed also influences the economy through the money supply. They do this in two ways – buying and selling securities and adjusting the interest rate that banks earn on reserves.
During a recession, the Fed may engage in quantitative easing, or buying securities. They may also lower the interest paid on excess reserves to encourage lending and stimulate the economy.
During prosperous economic times, the Fed may reduce their purchases of securities or sell securities that they hold – known as quantitative tightening. They may also increase the interest paid on excess reserves to encourage banks to keep more capital, further reducing the money supply.
How Fiscal and Monetary Policy Impact Investors
Both fiscal and monetary policy seek to even out extremes in the business cycle and provide long-term stability which benefits investors in the long run. However, both types of policy can cause short-term volatility in your portfolio.
Restrictive monetary policy – which is used to slow the economy – typically results in slower business growth and lower stock prices. This type of policy often includes higher interest rates which cause bond yields to rise and prices to fall. Elevated interest rates can also cause higher yields for cash investments, like money market funds. On the other hand, real estate investments often slump when interest rates increase because fewer buyers are interested in taking on debt at higher rates.
Accommodative monetary policy – which is used to bolster the economy – typically has the opposite effect including stronger performance from stocks, lower bond yields, and less attractive interest rates for cash investments. When interest rates are low, real estate tends to do well since buyers can take advantage of low-rate loans.
Economic shifts are difficult to predict, as are the monetary and fiscal policy changes that accompany them. However, an experienced financial advisor can guide you through these changes and help you protect your investments.
Meld Financial Can Help You Prepare for Changing Fiscal and Monetary Policy
At Meld Financial, we can help you prepare your financial plan for changing economic conditions and policy decisions. Our team of tax, legal, and financial professionals have been guiding clients since 1984 and have navigated a variety of tumultuous economic changes.
Our team will develop your Financial Fingerprint® – a comprehensive wealth management plan designed to help you adapt to changes in the economy and investment markets. This nimble plan includes the most important aspects of your financial life including investments, tax planning, Social Security, and Medicare.
To learn more about Financial Fingerprint® and get started, contact us today.
