1.7 Economic Policies

Government and central bank policies have a profound impact on securities markets. Understanding monetary policy and fiscal policy is essential for the SIE exam - and for understanding why markets move.

Two Types of Economic Policy

Monetary Policy: Who Controls It - Federal Reserve (the Fed); Primary Tools - Interest rates, money supply

Fiscal Policy: Who Controls It - Congress and the President; Primary Tools - Taxes, government spending

Both aim to promote economic stability, but they work through different mechanisms.

Monetary Policy

Monetary policy refers to actions by the Federal Reserve to influence money supply, credit conditions, and interest rates. The Fed has a dual mandate from Congress:

1. Maximum employment - Keep unemployment low

2. Price stability - Keep inflation in check

The Fed's Policy Tools

Federal Funds Rate: Target rate for overnight bank lending

Open Market Operations: Buying/selling Treasury securities

Reserve Requirements: Share of deposits banks must hold (ratios set to zero since March 26, 2020)

Discount Rate: Rate Fed charges banks for emergency loans

Open Market Operations

Open market operations - buying and selling Treasury securities - are another Fed tool:

- To stimulate the economy: Fed buys securities, increases money supply, lowers interest rates

- To slow inflation: Fed sells securities, decreases money supply, raises interest rates

Expansionary vs. Contractionary

Expansionary Policy: Lower interest rates; Buy securities (inject money); Stimulate borrowing and spending; Combat recession/unemployment

Contractionary Policy: Raise interest rates; Sell securities (remove money); Cool down overheating economy; Combat inflation

Federal Funds Rate

The federal funds rate is the interest rate banks charge each other for overnight loans. It's the Fed's primary policy lever.

Why It Matters

- Changes in the fed funds rate ripple through the entire economy

- Affects consumer loans, mortgages, credit cards, and business borrowing

- Influences stock and bond prices

Rate Changes and Securities

Fed Raises rates: Bond Prices - Generally fall; Stock Prices - Often fall (higher borrowing costs)

Fed Lowers rates: Bond Prices - Generally rise; Stock Prices - Often rise (cheaper borrowing)

Quantitative Easing (QE)

When traditional tools aren't enough, the Fed may use quantitative easing - large-scale purchases of securities.

How QE Works

1. Fed creates new money electronically

2. Uses it to buy Treasury bonds and mortgage-backed securities

3. Increases money supply and lowers long-term interest rates

4. Aims to stimulate lending and investment

Recent History

The Fed used QE extensively after the 2008 financial crisis and during the COVID-19 pandemic, growing its balance sheet from under $1 trillion to over $8 trillion.

Fiscal Policy

Fiscal policy involves government decisions about taxing and spending. Unlike monetary policy (controlled by the Fed), fiscal policy is determined by Congress and the President.

Fiscal Policy Tools

Taxes: Expansionary - Cut taxes; Contractionary - Raise taxes

Spending: Expansionary - Increase spending; Contractionary - Decrease spending

Goal: Expansionary - Stimulate economy; Contractionary - Slow inflation

Fiscal vs. Monetary: Key Differences

Controlled by: Monetary Policy - Federal Reserve; Fiscal Policy - Congress/President

Independence: Monetary Policy - Independent of politics; Fiscal Policy - Subject to political process

Speed: Monetary Policy - Can act quickly; Fiscal Policy - Often slow (legislation required)

Primary tools: Monetary Policy - Interest rates; Fiscal Policy - Taxes and spending

How Policies Affect Securities

Impact on Stocks

Fed cuts rates: Positive - lower borrowing costs

Fed raises rates: Negative - higher costs, lower valuations

Tax cuts: Positive - higher corporate profits

Increased government spending: Positive - more economic activity

Impact on Bonds

Bond prices have an inverse relationship with interest rates:

- When rates rise, existing bond prices fall

- When rates fall, existing bond prices rise

This is because newly issued bonds offer better (or worse) rates than existing bonds.

Impact on Different Sectors

Financials: Benefit from higher rates (wider margins)

Utilities: Hurt by higher rates (dividend competition)

Real Estate: Hurt by higher rates (higher mortgage costs)

Technology: Hurt by higher rates (future earnings worth less)

Policy Coordination

Monetary and fiscal policy can work together - or at odds:

Aligned Policies

- During recessions, both may be expansionary (low rates + stimulus spending)

- This combination can be very stimulative

Conflicting Policies

- Fed tightening while government increases spending

- Can create uncertainty and mixed market signals

The Fed's Independence

The Federal Reserve operates independently from political branches:

- Fed Chair appointed by President, confirmed by Senate

- But day-to-day decisions made without political interference

- Independence helps maintain credibility on inflation control

Why Independence Matters for Markets

- Markets trust the Fed to focus on economic fundamentals

- Political interference could lead to short-term thinking

- Credibility helps anchor inflation expectations

Key Takeaways

- Monetary policy is controlled by the Federal Reserve and focuses on interest rates and money supply

- Fiscal policy is controlled by Congress/President through taxes and spending

- The Fed's dual mandate is maximum employment and price stability

- Open market operations (buying/selling securities) is the Fed's primary tool

- Interest rate changes affect both stocks and bonds, often in opposite directions

- The Fed's independence from politics is crucial for market confidence