The probable course of U.S. monetary policy is relatively clear when compared to fiscal policy. The uncertainty in fiscal policy, involving both government spending and taxation, relative to the clarity of monetary policy — taper asset purchases now and think about rates much later — has some interesting implications for the interplay between the U.S. economy and equity markets.
Our perspective is that equity markets and the economy are both greatly influenced by fiscal policy. Monetary policy has a more direct link to equities and much less so to economic activity. With both fiscal and monetary policies in motion at the same time, the analysis gets complicated rather quickly.
Let’s start with fiscal policy. The pandemic of 2020 was cushioned in a major way by huge direct payments to individuals, including unemployment insurance and food stamps, contained in the fiscal policy initiatives in 2020 from the Trump Administration and in 2021 from the Biden Administration. To understand the importance of direct payments to individuals, one needs to examine the path of personal consumption expenditures.
Back in the Great Recession of 2008, there was a $1 trillion fiscal policy program enacted in the closing days of the Bush Administration which focused only on “shovel ready” projects and did not provide any direct assistance to individuals, including the recently unemployed. The path of consumption expenditures never had a definitive rebound from the recession and took years to regain the pre-recession peak.
By contrast, in the 2020 pandemic, the massive fiscal transfers to individuals allowed for a sharp rebound in personal consumption and a quick return to the pre-pandemic trend path for consumption. It only took a few quarters, not years, to regain the pre-pandemic peak.
But those direct transfers to individuals have run their course. The next stage of fiscal policy is uncertain, although likely to contain a mix of multi-year infrastructure projects, some expansion of medical programs, climate initiatives, and tax increases. The positive influence on the U.S. economy is likely to be quite modest due to the nature of the spending and how it is spread over many years. The potential tax increases are unlikely to make much of a difference to business investment or to the economy, but there is a strong possibility that any increases in corporate income taxes will reduce future cash flows and be at least partly reflected in modest downgrades of equity valuations.
Now let’s shift to monetary policy.
When QE or asset purchase programs were first put in place by the Federal Reserve (Fed) in the U.S. as an emergency measure late in 2008 to respond to the financial crisis, there was no historical precedent. We now have 12 years of statistical evidence, and the conclusions contain some interesting elements. QE involving the Fed’s purchase of distressed securities in late 2008 definitively helped to put a floor under the recession driven by financial deleveraging. The QE that commenced in 2010 after the U.S. economy was already growing again was focused solely on purchases of U.S. Treasuries and mortgage-backed securities, and clearly provided support for asset prices, especially equities and fixed-income. What is interesting is that there appears to have been no impact on the real economy or on inflation from the type of QE conducted during times of modest economic growth. This strongly suggests that the withdrawal of QE or tapering of asset purchase programs will have most of its influence on asset prices, and little to no influence on the U.S. economy.
First, the U.S. economy is transitioning from its rapid rebound phase from the pandemic into a much slower, yet positive, growth path as the influence of the direct payments to individuals in the early fiscal policy programs have run their course.
Second, the details of future fiscal policy programs are highly uncertain yet likely to contain a mix of multi-year spending and some tax increases, especially on corporations and wealthy individuals. The multi-year spending on infrastructure is likely to have a modest impact on job creation, while the tax increases may reduce corporate cash flow and be associated with equity valuation recalibration.
Third, the tapering of asset purchases by the Fed is largely expected to be felt in asset prices, as support is slowly withdrawn, and to have little to no impact on the real economy or inflation. We would note that just because an economic event is well telegraphed and widely anticipated does not mean that the reality of the event will not have a big impact over time, just not all at once, as the case with surprises. The withdrawal of QE may be a big deal for equities and bonds when considered over time.
Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011. With more than 35 years of experience in the financial services industry and concentrations in central banking, investment research, and portfolio management, Blu serves as CME Group’s spokesperson on global economic conditions.
View more reports from Blu Putnam, Managing Director and Chief Economist of CME Group.
Enjoy potentially lower trading costs than ETFs plus margin offsets against other index futures using our contracts on S&P 500.