Fiscal policy vs monetary policy: the two titans of economic management

In the past couple years, Governments and Central banks have been busy adjusting their fiscal and monetary policies, to absorb the different financial and economic shocks caused by a plethora of global events (the COVID-19 pandemic, raw material shortages, geopolitical issues, etc.). Therefore I thought it might be useful to refresh the differences between two of the most influential tools that governments and central banks use to manage the economy: fiscal policy and monetary policy. Now, every country is different but we'll cover some examples from the U.S. and Europe. Plus, we'll explore how these policies can impact your investment strategies. Exciting, right?

Fiscal policy: the government's wallet

Let's start with fiscal policy. This is the government's way of influencing the economy by adjusting its spending levels and tax rates. It's like the government's wallet - they can decide to spend more, spend less, tax more, or tax less.

The responsibility for fiscal policy typically lies with the government, more specifically, the Ministry or Department of Finance or Treasury. In the United States, for example, the Department of the Treasury and Congress are the key players in defining fiscal policy. But let's hop across the pond to Europe. In Germany, it's the Federal Ministry of Finance that holds the fiscal reins.

Fiscal policy can be either expansionary (aimed at stimulating the economy) or contractionary (aimed at slowing down an overheated economy).

For instance, during the 2008 financial crisis, the U.S. government implemented an expansionary fiscal policy, which included the American Recovery and Reinvestment Act of 2009. This act, costing a whopping $831 billion, was designed to save and create jobs, provide temporary relief programs for those most affected by the recession, and invest in infrastructure, education, health, and renewable energy. And when the Covid-19 pandemic shook the world, an even larger program was launched, called CARES 2020, with more than $2 trillion at its disposal.

In Europe, a similar approach was taken. In 2009, Germany launched a €50 billion fiscal stimulus package to combat the recession, focusing on infrastructure projects and tax cuts to boost the economy. And when later the COVID-19 pandemic arrived, different initiatives were launched across Europe (e.g. SURE, EIB, NextGen EU, etc.) totaling an amount similar to the CARES act.

Overall the elements and levers that governments can use are indeed similar, however since each country has different needs and budgets, the support allocation does differ. A good example comes from an analysis from the International Monetary Fund (IMF) in one of their publications from 2021 called Fiscal monitor:

But how does this impact your investment strategy? Well, expansionary fiscal policies can lead to economic growth, which can boost corporate profits and, therefore, stock prices and dividends. On the other hand, contractionary fiscal policies can slow the economy and potentially depress stock prices. So, keeping an eye on fiscal policy can help you anticipate market trends and adjust your investment strategy accordingly.

Monetary policy: the Central Bank's magic wand

On the other hand, we have monetary policy, which is typically managed by a country's central bank. In the U.S., this would be the Federal Reserve (or the Fed, as many people call it). In Europe, it's the European Central Bank (ECB) that takes the lead.

The central bank can manipulate the money supply, interest rates, and other financial conditions to influence the pace of the economy's activities. Monetary policy can also be expansionary (to stimulate the economy) or contractionary (to cool it down). For example, in response to the COVID-19 pandemic, the Fed slashed interest rates to near zero in March 2020. This was an expansionary monetary policy move aimed at encouraging borrowing and investment to boost economic activity.

Similarly, the ECB also took drastic measures during the pandemic. It launched a €1.85 trillion Pandemic Emergency Purchase Programme (PEPP) in March 2020 to buy government and corporate debt, aiming to keep borrowing costs low and stimulate the economy.

From an investment perspective, monetary policy can significantly impact your decisions. Lower interest rates can make borrowing cheaper, potentially leading to increased corporate profits and higher stock prices. They can also make bonds less attractive compared to stocks due to lower yields. On the flip side, higher interest rates can increase borrowing costs, potentially reducing corporate profits and lowering stock prices. They can also make bonds more attractive due to higher yields. So, understanding monetary policy can provide valuable insights for your investment strategy.

The dance between fiscal and monetary policy

While both fiscal and monetary policies aim to maintain economic stability, they often have to dance together to achieve this. For instance, during the Great Recession, the U.S. government's expansionary fiscal policy (increased spending and tax cuts) was complemented by the Fed's expansionary monetary policy (lowering interest rates and quantitative easing).

In Europe, the dance can be a bit more complex due to the unique structure of the European Union, where fiscal policies are decided at the national level, while the ECB sets the monetary policy for the entire Eurozone. This was evident during the Eurozone crisis, where the ECB implemented expansionary monetary policies, while many national governments, such as Greece and Spain, were forced to implement contractionary fiscal policies due to high levels of debt.

If we take even just the past 3 years, the mix of fiscal and monetary policy has changed significantly:

As an investor, understanding this dance can help you anticipate potential economic trends and make more informed investment decisions. For example, a combination of expansionary fiscal and monetary policies could signal a good time to invest in stocks, while a combination of contractionary policies could suggest it might be a good time to move towards more defensive assets like bonds or cash.

The bottom line

In the end, both fiscal and monetary policies are crucial tools for managing an economy. They're like two sides of the same coin, each with its own strengths and weaknesses. The key is to find the right balance between the two, which can be a tricky task.

So, the next time you hear about the German government adjusting tax rates or the ECB changing interest rates, you'll know what's going on. You'll understand that these are not random actions, but strategic moves in the grand chess game of economic management. And more importantly, you'll have a better idea of how these moves could impact your investment strategy.

Until next time, keep your economic curiosity alive and remember, every policy has a story behind it. Whether it's the U.S. or Europe, the dance between fiscal and monetary policy continues to shape our economic landscape and our investment opportunities. Happy exploring and investing!

And if you want to learn more about Central banks, make sure to check my deep dive.