A framework we like to use to think about the interplay between fiscal and monetary policies is something we’ll call string theory. If the economy is a kite, then monetary policy is the string. Normally, the central bankers of the world prefer to establish a stable monetary policy that allows our economic kites to fly higher, but not too fast as too much string/slack could lead to runaway inflation and flyaway kites. Thus, there are always periods of adjustments, sometimes tension (i.e., monetary policy) on the line is increased and other times decreased. In times of distress though, central bankers will relax the tension and allow the kites to catch any wind as the breeze of demand wanes.
While decreasing tension and giving more line can help, ultimately the kites still need wind (i.e., demand) to fly. In a normal functioning economy, this demand is fairly stable, but in a COVID world? Not so much. This is where fiscal stimulus (i.e., government spending) can step-in and provide an updraft to keep the kite aloft until normal trade winds recover. Aggressive fiscal stimulus can help bridge us over the challenging times by temporarily lifting consumption. In essence, what the free market can’t provide, government spending/funding can generate.
Without fiscal stimulus, however, monetary policy alone will likely be insufficient when economic activity falls too quickly. Without adequate demand, without a breeze, giving the kite more line proves ineffectual. Central bankers are effectively pushing on a string. So ideally, the economy needs the government to provide both as the country recovers from the COVID pandemic. Unfortunately, things are seldom idyllic when politics are involved.
Monetary Policy
Let’s start with Monetary Policy. As we’ve noted in our past few newsletters, the Federal Reserve has committed to a framework of loose monetary policy going forward. Here they are should you need to reference them:
Issue 5: Inflation? Buckle Up . . .
Issue 6: All You Can Eat . . . Inflationary Assets
It’s a stance they reiterated a few days ago after holding a two day meeting. Short-term interest rates will remain targeted at 0-0.25%, and officials will allow inflation to rise above 2% before contemplating raising rates. None of these announcements were a surprise as the Federal Reserve had well telegraphed their plans ahead of time, but the reaffirmed commitments further cements the new policy direction for years to come (at least until 2022/23).
The Federal Reserve also reduced expectations for a stronger rebound in GDP in 2021, reducing GDP forecast from 5% to 4%, following a 3.7% collapse in 2020. Even with the 1% reduction, this is still effectively a full recovery.
The Waning Wind
The true velocity of that recovery, however, will likely require one thing, more fiscal stimulus. As Congress has stalled in their search for a “CARES Act 2.0” deal, the economic recovery and stock market has floundered. The lack of additional fiscal stimulus means the economy faces daunting challenges even as COVID cases in the US plateau.
Although many states are recovering, with some states reopening quickly, rising COVID cases in the Midwest continue to cast a pall over our economic recovery. The unemployment rate remains high, and initial jobless claims are still significantly elevated as the travel and service economy remains hobbled.
Moreover, temporary job losses are now crystallizing into permanent job losses.
Airline executives, labor unions, etc. have all called upon Congress to agree to a package before it recesses in the coming days for the election. Failing to pass another round of stimulus means we’ll head into the election with little economic support as layoffs mount and foreclosures/evictions increase.
Once clear of the elections, the political situation may deteriorate further from November to late-January as we’ll continue on with our divided government, and one likely occupied by “lame-ducks.” If Republicans lose both the White House and Senate, government grid- lock out of spite, or political strategy will dominate. Republicans won’t want to give the incoming administration momentum as they refocus on 2022 mid-term elections. The political impasse means legislative activity will grind to a halt, and the chances of any fiscal stimulus being approved will have passed us by unless the economy free-falls, or an emergency forces the government to act.
Post-inauguration in January, we can expect a fiscal stimulus bill, perhaps the vaunted Democrat “Green Deal” if Democrats win the Senate and the White House. Although if Republicans maintain control of the Senate then you can bet that Senate Majority Leader McConnell will revert to his Obama playbook to stifle President Biden’s first 100 days, the initial benchmark for how successful a President’s term will be. Thus, passing a fiscal stimulus between November to January just to give added momentum to an incoming Democrat administration? Unlikely. Passing a fiscal stimulus measure post-inauguration? The size, scope and ease will depend on the election’s outcome. Regardless of the outcome, we’ll have gone months without fiscal stimulus.
So said another way, this week is the last best chance to pass a fiscal stimulus package, and failing to do so means we’ll likely see a further fall in the markets and a much slower recovery. While the Federal Reserve continues to push on the string, we need need fiscal stimulus to generate some wind here to avoid layoffs and boost demand, while bridging us for a few more months before a vaccine can be rolled out (or a larger fiscal stimulus/infrastructure bill can be passed with a new administration).
On Monday the market continues to rally based on comments from the House Speaker Nancy Pelosi that the administration continues to discuss possible fiscal stimulus measures, but some of this is electoral posturing. The pressure is on Congress as members will almost surely face hostile electorates in town hall meetings (regardless of party affiliation) as they begin campaigning back home. We think it’ll be better to bring something home than show-up empty handed.
Interestingly as the central bank has paused its balance sheet expansion and the prospect for additional fiscal stimulus has weakened these past few months, inflation expectations have also declined slightly as has gold prices.
If Congress does wind-up agreeing to some form of stimulus, expect the above to reverse quickly as the inflation trade will regain favor. Further stimulus (i.e., free money from the sky) will also embolden retail investors to leap back into the mix and speculate with their newfound wealth. Nonetheless, even the risks of blowing a larger asset bubble outweighs the likely damage we’ll do to the economy if we don’t generate some tailwind and let the kite fall. For now, the Fed’s already done its part and given our kite some slack. Now it’s time for Congressional blowhards to do what they do best . . . blow.
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