Must-know: Why investors shouldn’t worry about fiscal policy

Whether in the US or abroad, monetary policy dominates fiscal policy

The budget sequester in the US and austerity measures in Europe have been a huge focus in the news over the last year. However, neither of these events has been the main driver of growth in developed markets. Instead, monetary policy has led the way.

But why is this the case? Surely a massive cutback in government spending should shrink the economy! Everyone learns in macro 101 that Y = C + I + G + NX, so if G goes down then Y goes down. The reason is that the Fed (or the prevailing central bank) is the last mover, and so it offsets any changes in government spending with its own policies.

11.11.13 monetary fiscalEnlarge Graph

Monetary offset of fiscal policy changes was in full display back in September, when the Federal Reserve gave the following reasoning for not tapering asset purchases:

  • “Taking into account the extent of federal fiscal retrenchment, the Committee sees the improvement in economic activity and labor market conditions since it began its asset purchase program a year ago as consistent with growing underlying strength in the broader economy. However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.”

This means the Fed adjusted its policies to be more expansionary than it would have been due to the expected contractionary impact of the sequester.

When it comes to business cycles, it’s all about the Fed

Real growth (Y or RGDP) is driven by nominal growth (NGDP) in the short run, and the Fed determines nominal growth by controlling the inflation rate. While changes in government spending can definitely affect industries that directly benefit from it, such as aerospace and defense, when looking to invest in broad market funds such as the S&P500 (SPY) or the Russell 2000 (IWM), investors should pay more attention to changes in monetary policy than to fiscal policy.