Learning how Monetary and Fiscal Policies Affect Markets
What you will learn
- What monetary and fiscal policies are
- How monetary and fiscal policies affect markets
What are monetary policy and fiscal policy?
Monetary policy refers to the management of interest rates and employment, typically by a country’s central bank. Fiscal policy refers to the levers that a government can pull to stimulate or slow down an economy. These levers include government spending and taxation.
The core objective of both monetary policy and fiscal policy is to build a productive and robust economy over the long term. Ideally, this means an economy that enjoys sustainable growth, low unemployment, and price stability.
A country's central bank seeks to achieve these objectives using a number of monetary policy tools, which regulate the supply of money. For example, in the United States, the Federal Reserve sets monetary policy goals, which includes maintaining inflation around a targeted band of 2%.
How does monetary policy affect markets?
Monetary policy is often described as either expansionary or contractionary.
Expansionary policy is used when the economy is weak and inflation is low. To increase the supply of money in circulation and encourage businesses and consumers to spend more, a central bank may lower interest rates with a goal of supporting growth in the economy.
Conversely, when the economy is overheated, as characterized by unsustainably high growth and high inflation, a central bank will deploy contractionary policy. This may involve increasing interest rates to discourage spending by businesses and consumers.
When an economy is performing well, a central bank would most likely keep interest rates on hold at their current levels.
Because of all the other factors that influence market performance, such as geopolitical events or where the economy is in the business cycle, it’s not possible to predict with certainty how financial markets will respond to changes in monetary policy. However, the table below offers some generalizations about how different segments of the investment markets have typically responded in the past.
Investments and monetary policy
| Equities (short-term response) | The short-term performance of equities in response to a rate change largely depends on whether the change was expected. If a change in interest rates was expected – regardless of whether interest rates are increased or decreased – the market should remain relatively flat. An unexpected change may generate stepped-up volatility and a short-term decline. |
| Equities (longer-term response) | Over the longer run, equity markets typically rally as interest rates fall because the market sees lower interest rates as a catalyst for growth. Conversely, when interest rates are rising, equity markets may cool. This is because higher rates may lead to higher debt expenses or reduced revenue for a company if demand for its products falls, which could mean lower profits and less growth. |
| Bonds | In a falling interest rate environment, bond prices rise, owing to the inverse relationship between bonds and interest rates. Low interest rates usually mean it’s easier and more attractive for companies to borrow money, and many will issue bonds as a way of doing so. This creates demand for higher yielding bonds, which in turn pushes up prices. The same is true in reverse, with higher interest rates pushing bond prices down. |
| Cash | Low interest rates reduce the interest paid to cash investors, which causes the return from cash equivalents and cash portfolios to decline. When interest rates are perceived as likely to go up, investors – depending on their risk tolerance and the shape of the yield curve – may see cash investments as more attractive. |
| Property | Of course, demographics and relative supply and demand must always be factored into real estate markets. But low interest rates often drive up the prices of real assets, such as property, as more people look to borrow money, which increases demand. Conversely, higher interest rates mean higher borrowing costs, which may mean fewer people will borrow to invest in property. |
How does fiscal policy impact markets?
The two key levers of fiscal policy are government spending and taxes. Changes in fiscal policy sometimes have a less direct impact on investment markets than is typically seen with shifts in monetary policy. Policy debates may sometimes affect market prices in advance of policy implementation, but the full ripple effects of fiscal policy decisions may not affect markets until much later.
The table below offers some generalizations about how equity markets have typically responded to changes in fiscal policy.
Fiscal policy and the equity markets
| Tax changes |
Generally speaking, an increase in taxes tends to dampen economic growth by reducing consumer spending and company profits. In turn, this would lead to a fall in the equity market. If taxes are lowered, consumers have more money to spend and companies have higher profits, supporting an increase in the equity market. |
| Spending | Different industries will respond differently, of course, but equity markets generally respond positively to increases in government spending in anticipation that economic activity will pick up. The reverse is true if a government cuts spending. |
Bond markets, generally, tend to be more attuned to monetary than fiscal policy, although some spending policies – a large infrastructure project, for example, may be financed by a large bond issue, and thus have a noteworthy impact on local or regional markets. Fiscal policy may have an indirect impact: higher growth expectations tend to lead to higher bond yields, and vice versa.
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