Over the last decade, the Federal Reserve has sought to spur growth primarily through adjustments to monetary policy. We watched as short-term interest rates moved to zero while the U.S. stock market rose to all-time highs; yet growth still languishes. Though monetary easing has guided the economy back to near full employment and inflation has been kept at bay, it has not pulled growth up toward the 2.5–3.0% rate considered to be sustainable in the U.S. In light of this, we believe that the market is building consensus around the idea that monetary easing alone cannot get the economy moving, further reduce unemployment, or nudge inflation toward the Fed's long term target of 2.0%.
This consensus has already become evident in the current presidential election. Both the Democratic and Republican candidates are proposing significant increases in spending or reductions in tax rates, aimed at stimulating the economy. With the U.S. government seemingly poised for a transition from a reliance on monetary easing to an emphasis on fiscal easing, we must consider the impact this could have on the market and the potential risks that come with it.
The Limits of Monetary Easing
Monetary easing has clearly had a positive impact on the economy since the global financial crisis in 2008. However, with interest rates held artificially low (that is, below nominal GDP) by the Fed, we've likely reached the limits of what it can accomplish.
Additionally, because monetary easing has been in effect for so long, it has led to some unintended, negative consequences: savers have been impacted by reduced interest on cash and fixed income securities, and equity investors have been faced with higher asset prices as falling fixed income yields sent more investors into the equity market. Bank earnings have also suffered, making them less likely to lend money. Though the Fed began to normalize interest rates with an increase of 0.25% in December 2015, the low and in some cases negative interest rates found in the rest of the developed world, particularly in Europe and Japan, are still moderating global growth expectations.
Fiscal Easing's Time Has Come
Given the current low interest rate environment, the government could play a powerful role in elevating economic growth. On the surface, government spending in the private sector would be supportive of growth, as it typically leads to new jobs, tighter labor markets, higher wages, higher tax revenue and more spending by consumers. However, it's important to note that new fiscal easing has traditionally been paid for by increasing U.S. debt — and increasing the country's debt is not without consequences.
At the end of 2015, the U.S. debt stood at 73% of GDP, and is projected to reach 85% of GDP by 2026, before any new spending is factored in. Though budget estimates do not always prove to be accurate, the most recent report from the Committee for a Responsible Federal Budget projects that Hillary Clinton's proposals would increase the debt-to-GDP ratio to 86%, and that Donald Trump's proposals would increase it to 105%. Figure 2 illustrates how differences between the two candidates' plans would lead to changes to the current deficit. The Clinton plan is projected to add an additional $200 billion to the deficit, while the Trump plan is projected to increase the deficit by an additional $5.3 trillion.
It's well understood that when countries carry debt that represents more than 100% of their GDP, additional spending can become counterproductive, due to increased sovereign credit risk and the withdrawal of foreign funds. Even before a country reaches that point, though, issues can arise.
Increased government spending can lead to a decline in the economic growth rate over time, due to a “crowding-out" effect. New private investment dollars may be diverted into buying government bonds rather than to individuals and companies seeking to grow wealth or fund business enterprises. Fiscal easing can also potentially lead to higher inflation, resulting in higher interest rates, which can then crowd-out private investment or spending by making it harder to borrow funds. This has the potential to effectively undermine the intended effects of fiscal easing. Additionally, consumers often react to increased government spending by saving more of their money, believing that it will ultimately need to be paid for by a future tax increase.
The Importance of Policy Cooperation
The impact of government policy changes on corporate spending over the last several years highlights the importance of fiscal policy and monetary policy working in concert to achieve U.S. economic objectives.
While consumer spending has improved dramatically since the recession in 2008–2009, capital spending by corporate entities has declined. This is in part due to a number of government policies that have served to offset the stimulative aspects of monetary easing, including:
- New healthcare mandates on businesses
- A more robust regulatory environment, particularly for financial institutions (the Volcker rule, Dodd-Frank)
- A decline in government spending due to sequestration-driven budget cuts (passed in 2012 and in place until 2021)
This demonstrates that, to some degree, the Fed and the U.S. Congress have been working at cross purposes. The impact of new regulations and fiscal spending cuts passed by Congress may have led to a longer, shallower recovery than we may have experienced otherwise. Cooperation between these two entities is challenging, as the Fed must remain independent, but the success of monetary and fiscal easing policies relies upon everyone moving toward the same goal.
Funding Fiscal Stimulus
Beyond monetary and fiscal policy, the concept of “helicopter money" has captured many people's imaginations and is being seriously discussed in places like Europe and Japan. In an April 2016 blog post for the Brookings Institute, former Fed chairman Ben Bernanke described it as “a broad based tax cut combined with money creation by the central bank to finance the cut in an effort to stimulate growth and reflate the economy."
This strategy has come to be referred to as "helicopter money" because Milton Friedman, who first proposed it, described it as akin to throwing cash out of the windows of a helicopter to crowds below, who would enthusiastically pick up the money and spend it. Put another way, money transferred to the public would possibly lift aggregate demand for both spending and investment.
In one potential scenario, the government would spend money and issue bonds to pay for the spending. The Fed would then buy the bonds with freshly printed money and promise to never bring the bonds back into circulation. This should, in effect, influence the economy in a way similar to fiscal easing, but without adding to government debt. It would also avoid the crowding-out effect, and theoretically wouldn't lead to more consumer savings as there should be no expectation of a future tax increase.
The biggest obstacle to this policy approach in the U.S. is, as noted earlier, the difficulty of ensuring that the U.S. Congress and the Fed are in sync with one another. It is important to note that the Fed's mandate concerns monetary policy — not fiscal policy. Nevertheless, such coordination is necessary for helicopter money to be effective. Even if it could be achieved, however, it could present long-term problems related to the monetization of the debt issued as part of the process, as this could lead to higher than anticipated inflation. It could also introduce a slippery slope for legislators who might be tempted to use it to facilitate spending or tax cuts even when they no longer make sense, economically.
Furthermore, increasing the money supply may create a major economic headache for the U.S., as the value of the U.S. dollar could move lower, leading to currency devaluations in other parts of the global economy.
In any event, helicopter money has yet to become a topic of serious conversation in the U.S., and the circumstances under which such a strategy would be employed would have to be so extraordinary that it would hardly matter who was sitting in the White House come January.
In our view, after the dust settles in the weeks and months following this year's election, we can expect that the political process needed to evoke fiscal easing will likely get bogged down in Congress. Should Clinton win the presidential election, it is hard to imagine the proposed Democratic-sponsored fiscal easing programs getting through Congress if both houses remain controlled by the Republican Party. Even if Democrats take control of the Senate, it will take quite some time to negotiate a fiscal easing agenda in the early months of 2017. Further, should Trump win the presidency, we believe that his version of fiscal easing, largely based on tax rate reductions, would be seen by most congressional Republicans as dangerous to the budget balance within the next 10 years. We would expect that fiscal conservatives in the Republican Party would not be immediately supportive of using tax breaks that could lead to significant budget deficits in the future. Therefore, it seems unlikely that legislation reflecting Trump's current proposals would be passed.
Finally, the question of who is in charge of economic growth has always been the subject of debate. Should the Fed make it easier for individuals and companies to restart growth by lowering interest rates and employing quantitative easing? Or are we better off letting the government step in with additional spending to make up for what the private sector is unable to provide? Academic evidence supports both approaches. Public policy may soon catch up with that view. Whatever the outcome of the election, we believe that there will be a number of market opportunities that investors can take advantage of in the coming months.