MARKET COMMENTARY

Building Bridges: From Monetary Policy to Fiscal Stimulus

Third Quarter 2016 Perspective

09.22.2016 - Ronald J. Sanchez

It has been almost nine years since the Fed embarked on its extraordinary journey of accommodative monetary policy in its attempt to revive economic growth. During that time, policymakers pushed the fed funds rate down from 4.75% to near zero and added $4.5 trillion in government bond purchases to the Fed’s balance sheet.

Still, our tortoise economy continues to stumble forward.

What’s changing today is that central bankers and politicians appear to be in agreement that monetary policy has been shouldering the responsibility for economic expansion far too long and that it is time for fiscal policy (essentially, government spending approved by the legislature) to carry some of the weight.

As the US prepares to elect a new president this November, a groundswell of support has emerged for new economic catalysts such as government stimulus packages. While the bridge from accommodative monetary policy to expansionary fiscal policy is still in the conceptual stages, it appears that the blueprints are being drawn. As The New York Times explained recently, “Nothing is stopping elected representatives from coordinating with their central banker in a two-step process in which the central bank creates money and the democratic institutions spend it.”

How Did We Get Here?

When an economy is confronted with the types of systemic challenges we witnessed in the financial crisis of 2009, the ideal response is for policymakers and politicians to work harmoniously, regulating the supply of money and adjusting government spending in a way that promotes the creation of jobs and economic growth (but not runaway inflation).

In periods of duress, central banks typically pivot to an accommodative monetary policy, reducing the cost of borrowing for consumers and businesses, while legislators pursue expansionary fiscal policy, injecting a shot of adrenaline into the economy with pro-growth spending initiatives. It’s important to remember that the Fed and Congress operate independently, but their policy frameworks can work in tandem toward the same goal.

But while the Fed has been taking extraordinary measures to counteract the challenges of a deep economic recession, government stimulus spending has fallen behind, hitting a plateau shortly after Congress passed the $787 billion American Recovery and Reinvestment Act in 2009 (CHART 1). After the package was introduced, Congress shifted its focus to lowering the country’s deficit with automatic spending cuts across large swaths of the budget.

This newfound budgetary discipline in the face of a stubbornly slow economy left monetary policy in the difficult position of solely supporting the recovery. During a meeting in Jackson Hole, Wyoming this August, Fed chair Janet Yellen specifically mentioned “contractionary fiscal policy” as one of the many headwinds working against the US economy after the financial crisis.

Crossing the Bridge

Exactly how the US will cross the bridge from monetary to fiscal policy remains to be seen. The possibilities range from government funding for technological research and alternative energy to educational programs aimed at improving the quality of labor and enhancing workforce productivity.

Fiscal stimulus has emerged as a priority for government leaders around the world as they shift their focus away from extreme monetary policy, including $13 trillion in negative-yielding sovereign bonds, and toward pro-growth economic policies. Bank of England governor Mark Carney, Japanese Prime Minister Shinzo Abe and Italian Prime Minister Matteo Renzi are among those who have expressed a preference for government spending over austerity measures.

“Fiscal stimulus” has become the catchphrase of the day, now appearing in news articles almost as frequently as it did in 2009, the peak of the financial crisis (CHART 2).

One thing is clear: Modernizing America’s crumbling infrastructure has emerged as a leading contender for government spending. Infrastructure represents common ground between two presidential candidates who rarely see eye-to-eye. Democratic presidential candidate Hillary Clinton has earmarked $275 billion for repairs and $25 billion in loans and credit facilities to be held in a special infrastructure bank. Republican Donald Trump wants to allocate almost twice as much.

Infrastructure is appealing because most activity can be performed only in the United States, so it may create jobs and encourage personal consumption. Infrastructure spending also may have a multiplier effect if improvements to our transportation system also boost productivity.

Will Benefits Trickle Down?

Whatever form it takes, the re-emergence of fiscal policy as a more visible driver of economic growth could have far-reaching implications, influencing everything from government bond yields to capital gains taxes and the labor market.

It is possible that stimulus could encourage US corporations to start reinvesting in research and technology, expand their workforces and promote GDP growth. Without stimulus, business investment and capital spending are expected to be modest in the next several years (CHART 3).

In fact, without strong enterprise or government spending, consumers have been carrying the economy forward, albeit slowly. Personal spending now accounts for 69% of our nation’s GDP, a number that has been escalating steadily since 1950.

Finally, while an expansionary fiscal policy could awaken “animal spirits” and open corporate purse-strings, it comes with risks. For instance, while inflation has been stubbornly absent throughout the recovery, the specter of 1970s era elevated inflation looms large for many policymakers.

Furthermore, the benefits of any stimulus package will be limited by its scope and the intestinal fortitude of US legislators and taxpayers. Nudging a tortoise economy out of its lethargy will take time and money.


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