It seems that the topics of inflation and interest rates have been all over the news this year, as buying groceries and owning a home have both become expensive ventures in their own right. The Federal Reserve’s September meeting is expected to reveal the first interest rate cut since March 2020. With that impending news, it might be helpful to look at two of the main influences on the U.S. Economy, which may seem cloaked in mystery to the Average American: Monetary Policy and Fiscal Policy. This article will explore each of them and their impact on our lives.
Monetary Policy
This refers to the actions taken by central banks, including the Federal Reserve (AKA, The Fed), to affect change in the economy on a macro level. The government created the Fed to manage the money supply and prevent economic collapse. Their policies are intended to impact employment (in a good way), economic growth, and, most notably, prices of goods. Monetary Policy deals directly with interest rates and the economy's money supply.
Interest Rates
This is the buzzword for many. An interest rate is the price an individual or entity pays to borrow money from the lender. The home mortgage is perhaps the most talked about type of loan impacted by interest rates, but car loans, credit card interest and even bond yields are other notable arenas where interest rates reign. You might wonder what goes into changing interest rates. How do they go up, and how do they go down? This can be a complicated question, but we’ll put it simply. The Federal Reserve raises interest rates when the economy heats up. This can help them achieve their goals of stabilizing prices and maximizing employment. The Fed will cut rates when the economy has cooled, in an attempt to reignite economic activity (get people to spend their money). The adjustments of interest rates are reactionary, and the overall success of the macro-economy is (supposed to be) in their best interests when doing so.
Money Supply
This is a bit more complicated. Money is far more intangible than many of us think it to be. It all goes back to the advent of paper money, which served as a depositor’s receipt, representing the value of a stash of metal somewhere else, without requiring the owner to lug it around with them. The paper (or plastic) we carry now is merely a representation of a tangible thing that is somewhere else.
Is your head spinning yet? I recommend the book “Money – the true story of a made-up thing” which delves deeper into this topic and the history of money for further learning. I’ve digressed, so let’s move back to how the Fed impacts the money supply.
By adjusting the monetary base, or amount of money in circulation, and the amount of money required to be on deposit with the reserve, they can help cool or heat up the economy, whichever is needed.
There’s far more that could be said about monetary policy, but simply put, it is less political than fiscal policy and more about keeping the economy functioning than anything else.
Fiscal Policy
This is far more entangled in politics as it pertains to the government’s revenue. Fiscal policy boils down to two main things: Taxes and Government Spending. It’s all about the government’s balance sheet and deals directly with the government's ability to fund its operations, which can also impact economic growth.
Taxes
As you may have noticed, taxes are constantly changing. You may have also noticed that with each newly elected regime, the tax code takes on a particular flavor that jives with the policy of that regime. How does that actually happen, though? In short, it looks like this: In order for a new tax to be implemented, it has to pass through Congress and work its way up the chain of command, and then it gets written into law as part of our lovely tax code.
Government Spending
As I write this, the national debt sits at around $35,000,000,000,000. Actually, it isn’t sitting at all but climbing by the hundreds of thousands each second. Take a look for yourself here. The bottom line is that to operate this country, the government has to spend money. How they get that money is simple: They bring in tax revenue and sell debt. However, the things on which they spend that money is a hot debate topic that I don’t intend to ignite here. Government spending is the second of two critical footers upon which the fiscal policy is built.
Selling Debt
This refers to Government Bonds. Simply put, when the Government needs money to fund their spending (always), they issue bonds to the public. When you buy a bond, you’re loaning money to the government. In return, they promise to return that money to you and pay you interest, making you the lender in the relationship. This provides the government with the cash it needs to operate while it provides the investor/lender a safe investment with clear expectations, backed by the full faith and credit of the U.S. of A.
You might notice a beautiful dovetail of the Monetary and Fiscal policies in the above example, as interest rates play an essential role in the transaction. Though the country’s monetary and fiscal policies are separate and set by separate entities, they’ll forever be intertwined.
If you have questions about these topics or about investing, please reach out to our team of financial advisors.
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