Tug of War: How Fiscal and Monetary Policy are Pulling in Opposite Directions
Inflation is a rise in the aggregate price level of goods and services. Or said differently, inflation occurs when the value of a currency (in our case the US Dollar) depreciates relative to the value of goods and services that that currency can be used to purchase. At our internal Investment Committee meetings, we have allocated a significant amount of time to understanding the causal forces behind inflation, how changes in the Consumer Price Index (CPI) impact financial plans, consumer psychology, asset markets, and the behavior of investors. In this piece, I will elaborate on the differences between fiscal policy-driven inflation and monetary policy-driven inflation, using the 1940s and 1970s as historical corollaries. Before jumping in, I should note that there are very few original ideas in the world of finance and economics and my thoughts on this topic have been informed primarily by the work of Lyn Alden of Lyn Alden Investment Strategy and Jim Bianco of Bianco Research.
Monetary and Fiscal Policy
Members of the Federal Reserve (via monetary policy) and congress and the president (via fiscal policy) both have the ability to influence the rate at which consumer prices change over time.
Monetary Policy refers to the actions undertaken by a country’s central bank (such as the Federal Reserve in the US or the European Central Bank in the Eurozone). Central banks can implement monetary policy in various ways, including adjustments to short-term interest rates, open market operations (such as Quantitative Easing or Quantitative Tightening), and by managing reserve ratio requirements (the amount of reserves that commercial banks must hold against their deposits). Whereas conducting open market operations and adjusting reserve ratio requirements are secondary monetary policy tools, central banks primarily rely on their ability to manage short-term interest rates (“the cost of money”) when attempting to influence consumer prices, the labor market, or the trajectory of economic growth more broadly. Low interest rates are thought to encourage borrowing and economic activity and high interest rates generally discourage demand for new loans and reduce economic activity.
Fiscal Policy refers to the use of government spending and taxation to influence the economy. In the US, congress (the legislative branch) and the president (the executive branch) set fiscal policy by deciding the level of government spending, tax rates, and transfer payments (such as welfare benefits, unemployment insurance, and social security). The difference between the level of public sector spending and the amount the government receives from tax payments and other fees determines whether the fiscal budget is in a deficit or surplus, and of what magnitude. A government budget deficit creates a private sector surplus and is likely to boost economic activity. Federal surpluses result in private sector deficits and may have negative impacts on the trajectory of economic growth.
Historical Perspectives
In the 1970s, the majority of broad money supply growth was the result of bank lending. That decade experienced the highest sustained credit (loan) creation growth rate because members of the Baby Boom generation were beginning to enter their home-buying years. The building and mortgaging of new homes in the 1970s resulted in lending-driven growth of the money supply. When this rapidly increasing money supply encountered real world supply constraints, inflation ensued. However, once committed to, tight monetary policy (very high interest rates) increased the cost of mortgage loans, car loans, and other forms of debt. As the cost of new loans became prohibitively high for many consumers, economic activity declined and the balance between supply and demand was restored. As this example shows, monetary policy is particularly well suited to quelching inflation that is driven by new loan creation (primarily through the banking sector).
In contrast, the late 1940s was also a period of high inflation and supply chain bottlenecks. During this period, bank lending was extremely low but the money supply in the US economy still grew considerably due to large and sustained fiscal deficits. Simply put, the federal government spent much more money into the economy than was taxed out of it. Deficit spending was primarily directed toward helping US manufacturers retool their operations to support the war effort in Europe and other social programs that were enacted during the Great Depression. When WWII ended and soldiers returned home, private sector businesses had yet to come off their war footing and resume mass production of consumer goods. This combination of economic forces coalesced in a mismatch between high demand for goods and services and limited available supply, which resulted in rapid price increases that quickly abated as deficit spending was reduced and manufactures returned to normal operations in post-WWII period. Although monetary policy remained accommodative throughout the 1940s it is unlikely that higher interest rates could have meaningfully stemmed price growth, considering the inflationary impact of large fiscal deficits.
Inflation in the 2020s
To date, the 2020s have firmly been in the 1940s camp of fiscal policy-driven inflation. In 2020 and 2021, the size of the federal deficit surpassed the aggregate amount of bank lending by the largest margin on record. After mean reverting in 2022, the data series are again on divergent courses, with the fiscal deficit forecast to exceed aggregate new bank loan creation by a wide margin in 2024. Remember that monetary policy (interest rate adjustments) primarily impacts the economy by influencing the level and rate of change of bank lending. When the size of the fiscal deficit dwarfs the amount of new loan creation, tight monetary policy is likely to be less impactful than it otherwise would be because lending growth is not the primary contributor to money supply growth and inflation. In our view, this dynamic of “fiscal dominance” is critical to understand when considering the resilience of inflationary pressures in the face of what may otherwise be restrictively high real interest rates (real rates = nominal rates – inflation).
Furthermore, and somewhat counterintuitively, today’s monetary policy (high interest rates) may actually be imparting a stimulative effect on the domestic economy and consumer prices. The supporting rationale for this claim is that households and businesses are now receiving significantly more interest income on their cash investments than they have in recent years. This increase in interest income has yet to be offset by higher debt servicing costs, as the overwhelming majority of home mortgages in the US are locked in at much lower fixed interest rates, and most outstanding corporate debt has yet to need to be refinanced at today’s prevailing yields. Although the aggregate US private sector debt service ratio has risen from ~13.5% to ~15% since early 2022, as outstanding debt gradually comes due and is refinanced at higher interest rates, this figure is still only middling by historical standards and has yet to have a notable impact on consumer and business spending. Over time, should the level of real interest rates remain positive, the debt service ratio will likely continue to rise and gradually reduce the amount of corporate and household cash available to drive increasing demand for goods and services. With respect to the last point, it is important to keep two things in mind, 1) monetary policy is notorious for impacting the economy only after “long and variable lags” (which may be even longer and more variable than usual in this economic cycle), and 2) any disinflationary impact of monetary policy will probably be partially offset by inflationary fiscal policy.
In the near term, the Red Oak Financial Group Investment Committee (informed by the forecasts of our partners at Hedgeye Risk Management), does not anticipate the Consumer Price Index to revert toward the 2% level that Americans have become accustomed to over the preceding three decades. As asset allocators, we will continue to monitor the guidance provided by and the actions undertaken by the monetary and fiscal authorities, in the US and abroad. Given our belief that fiscal policy is currently a primary factor impacting the level and rate of change of US economic growth and inflation, we will be particularly keen to take note of changes to such policy as we evaluate accumulation and decumulation plans and asset allocation strategies on behalf of our clients.
Aaron
