With the political and monetary realms so tightly entwined -- perhaps now more than ever, as President Donald Trump has been more open than past presidents in expressing his views on the Federal Reserve's actions -- we thought members might benefit from an explainer on how fiscal and monetary policy work. In the following white paper, we'll delve into what tools policymakers use, how these interact with one another and the expected end results these actions can have on consumers, and thus on the companies that we invest in.

Fiscal vs. Monetary Policy

You've probably heard the terms "fiscal policy" and "monetary policy," but what exactly are they?
Well, the CFA Institute defines monetary policy as "central-bank activities that are directed toward influencing the quantity of money and credit in the economy." Fiscal policy refers to "government's decisions about taxation and spending," according to the institute.
Basically, when we say "fiscal policy," think U.S. government, and when we say "monetary policy," think the Federal Reserve or other countries' central banks. Both policies can be "neutral," "expansionary" or "contractionary."

Expansionary vs. Contractionary Policies

Neutral policies look to keep the economy chugging along at its current pace, while expansionary ones are those enacted in hopes of stimulating economic growth in hard times. Conversely, contractionary policies look to slow growth, perhaps because the economy is running "too hot" for its own good, causing inflation above what seems acceptable (usually around 2% a year). Let's focus on the latter two kinds of policies.
Expansionary policies look to stimulate the economy by directly or indirectly increasing the supply of money in circulation. The thought is if people have more money, they'll spend more (i..e, aggregate demand will increase).
Contractionary policies are the opposite in that they aim to directly or indirectly pull money out of circulation. If people feel their wallets are more constrained, they'll look to spend less, especially on items not deemed necessities. This will put less upwards pressure on prices, reducing inflation and slowing economic growth.
Before looking at how these policies work, we should mention their goals and why they're so important. According to the CFA Institute, "the overarching goal of both monetary and fiscal policy is normally the creation of an economic environment where growth is stable and positive and inflation is stable and low."
In such an environment, individuals can better make decisions regarding how much money to save and how much they can spend. Similarly, businesses can concentrate on daily operations and investments without worrying too much about external economic shocks. In other words, of the future is more predictable, it's easier to plan.
It's also worth mentioning that while the U.S. government or the Fed can directly implement a range of expansionary or contractionary policies, they can only hope that these moves have the desired outcome. Everything we'll discuss here is how things should work in theory. The actual outcome might differ from what the policymakers had hoped for. That's one reason why we often see so much debate regarding what policy is the right one to enact.
With that in mind, let's dig a bit deeper into fiscal vs. monetary policy.

Fiscal Policy

Let's say the U.S. government has decided to enact an expansionary fiscal policy. It can do this by either increasing spending, decreasing taxes or both. These policies would be expansionary because both serve to stimulate the economy, although through different mechanisms.
Government spending takes many forms -- transfer payments (health benefits, S ocial Security, etc.), investments in goods and services (i.e. student loans or defense spending) or infrastructure projects (roads, prisons, etc.) Through these spending initiatives, the government can improve living conditions, create jobs, increase productivity or make payments directly to citizens.
One real-world example of increased government spending is President Trump's recent $1 trillion infrastructure plan. By funding this plan, the government is in effect creating jobs, as workers will be needed for the newly planned projects. With more people employed, more money will enter circulation as overall income increases.
Total U.S. gross domestic product will also potentially increase, as there's a greater potential for the country to create more goods and services. After all, not only will the economy benefit from new jobs, but by improving things like roads or bridges, companies can more efficiently transport the resources used in production. Increased productivity also means more goods in less time and at lower costs. More goods and services coupled with lower costs also lead to higher GDP.
Alternatively, the government can choose to expand the economy by cutting taxes. Taxes come in two forms -- "direct" and "indirect" taxes.
A direct tax is placed on things such as income or capital gains, as the government is directly taxing citizens on the money they make. Cutting direct taxes makes people feel they're wealthier, thanks to an increase in disposable income (the income a person has left over after paying taxes). Disposable income is used to pay for both necessities and luxuries. If we assume that rent and related costs are kept stable, an increase in disposable income will allow for more spending money after these items (and savings) are accounted for.
"Indirect" taxes are placed on goods and services, as the government is indirectly taxing citizens by raising prices on goods that they consume. Examples of indirect taxes include sales taxes and "product-specific" taxes like those on tobacco or sugary beverages. By reducing indirect taxes, goods effectively become cheaper.
Let's say we want to buy a new car for $20,000 and there's a 10% tax on it. The end price to us will be $22,000 ($20,000 plus a $2,000 tax). We don't really care what percentage goes to the government and what percent goes to the manufacturer, just that we pay're paying $22,000.
But if the government decides to cut auto taxes to 5%, the result would be a $20,000 car with only $1,000 in taxes. Again, we don't care who gets what -- the government or manufacturer -- just that the same car now costs only $21,000. This reduction in price will allow people to buy more, or to proceed with purchases they had been planning on but felt they couldn't afford just yet.
Understanding how these policies act to stimulate the economy, we can see how an increase in government spending while decreasing taxes would only magnify the end effect. Prices decline, while jobs are created, productivity is enhanced and living conditions improve.
Now that we understand how expansionary policy works (through increased spending and decreased taxes), we can infer how a contractionary policy may work.
If the government feels the economy is running too hot, it can either reduce spending, increase taxes or both. If the government wants to slow the economy through decreased spending, it might cut or reduce transfer payments such as welfare or health benefits or reduce investments in things like education, defense or roads. By reducing spending on these initiatives, hiring will slow, people will feel they have less money to spend on luxuries and overall economic output will decrease.
People will be forced to redirect their disposable income to essential items such as health care. In the case of lower-income families, a reduction in welfare checks or food stamps might mean redirecting income away from "luxury" purchases (i.e., non-necessities) to those things that government subsidies once helped pay for but no longer do to the same extent.
Another way to reduce spending could be to cut subsidies on businesses. If the government previously provided a subsidy to companies for the goods they produce, those goods were being produced for a price lower than they would otherwise have cost to make.
If the government were to remove the subsidy, the company would be forced to make up the difference. The added expense would weigh on the business -- as their cost of goods sold would rise -- and would probably get passed along to the consumer. So, removing a subsidy on businesses is like removing government payments to citizens.
The other contractionary option that governments have is to increase taxes. Again, this can be done via an increase in direct or indirect taxes.
If the government decides to increase taxes directly on its citizen through income or capital-gains taxes, the result is less disposable income (income after taxes). When people have less disposable income, they think twice before making a purchase.
Looking at the example we used above, assuming rent and similar costs remain stable, a reduction in disposable income means less money left over after accounting for these expenses. That leaves less available for spending on luxuries or savings. If we have less left over to spend, we have to push out some of the purchases we were planning to make or give up on them completely, as we are forced to redirect income to the more crucial expenses.
The government could also choose to increase indirect taxes. It's worth noting that the government could do this not only to slow the economy, but to deter citizens from practices seen as "less desirable," such as smoking or consuming sugary drinks. If a pack of cigarettes used to cost $5 and now costs $15 thanks to higher taxes, you might finally give up smoking.
The government might also place a higher tax on fuel to encourage citizens to car pool or invest in electric vehicles. Officials might even do things such as raise fuel taxes while providing a subsidy on electric vehicles, further pushing consumers to adopt technology that's cleaner or more desirable (at least according to the government).
By enacting these higher indirect taxes, goods in effect become more expensive. Assuming we're in the market for a new car, we can see why this would be the case.
As noted above, if we're considering purchasing a $20,000 car taxed at 5%, the end cost to us is $21,000. But if the government raises auto taxes to 10%, the end cost to us is $22,000. Again, we don't care why it's more expensive or who gets what portion of our payment, just that we must now spend more for the same item.
Just as with expansionary policies, if the government were to both decrease spending while increasing taxes, the result would be magnified. Citizens would now be looking at more expensive goods with less disposable income, a slower job market (perhaps even layoffs) and a reduced growth rate.

Monetary Policy

Now that we understand how fiscal policy works, we can look at monetary policy.
Just as the government has tools to achieve its goals, central banks like the Federal Reserve have their own means of enacting an expansionary or contractionary policy.
Monetary policy is generally enacted in one of three ways: increasing or decreasing the interest rate, buying or selling securities in the open market, or increasing or decreasing the so-called "reserve requirement" placed on banks.
From an expansionary perspective, if a central bank decides to lower interest rates -- as the Fed did following amid the 2008 recession -- borrowing becomes cheaper. The rate the central bank sets is basically the rate at which it will lend money to commercial banks. The commercial banks can then turn around and lend money to businesses and consumers. Since the commercial banks are getting the money at a reduced cost, they can pass on some of the savings to borrowers, and if it's cheaper to borrow money, more people will look to borrow and invest.
Making it cheaper to borrow in effect allows more people to open new businesses or expand existing businesses and hire more employees at a lower cost. Lower interest rates also mean cheaper rates on mortgages or car loans, incentivizing citizens to make such big purchases.
If the Fed decides to go the open-market route instead of cutting rates, it will look to buy or sell government bonds, the counterparty being commercial banks (Wells Fargo ( WFC) , Citigroup ( C) , etc.) or chosen market makers. If the Fed wants to stimulate the economy -- again, think the 2008 recession -- it will buy government bonds from commercial banks and give them cash that the firms can then lend out to consumers. With more cash on hand, the banks can potentially lend at lower rates due to increased money supply. Consumers, in turn, can more easily afford to move up their plans to buy new houses or car or expand their businesses.
The final major way in which the Fed can enact an expansionary policy is by lowering the so-called "reserve requirement" on banks, although it's worth noting that this method is becoming less popular in developed countries.
Banks are required by law to hold a certain percentage of their money in reserve. For example, if a bank has $100 of customer deposits on hand and the required reserve is 25%, it can only lend out $75. The bank must keep the remaining 25% on hand as a "reserve" in case customers with savings in the bank show up to withdraw funds.
But if the required reserve were to be lowered to, say, 15%, the bank could loan out $85 rather than just $75. That would allow for more money to enter circulation. By lowering the required reserve, the Fed can indirectly get more money released into the economy, leading to higher levels of consumer borrowing, business investments and overall economic demand.
But just as with fiscal policy, if these monetary policies are reversed, the effects would be reversed as well. If the Fed increases interest rates, borrowing becomes more expensive and people are less inclined to take out loans to start businesses, buy homes, etc.
And if the Fed decides to sell rather than buy bonds on the open market, those securities are being traded in for cash and the Fed has effectively pulled money out of circulation. Finally, if the Fed were to increase the reserve requirement, it's effectively telling banks they can't lend as much as they once did -- reducing the available supply of loans and putting upward pressure on interest rates.

Monetary- and Fiscal-Policy Interactions

Now that we've looked at these policies independently, let's look at how they can interact with each other.
At any given time, both monetary and fiscal authorities have their own policies in place. So, there are four possible policy combinations (excluding the possibility of either branch maintaining a neutral policy):
1) Expansionary fiscal and monetary policies;
2) Contractionary fiscal and monetary policies;
3) Expansionary monetary policy but contractionary fiscal policy;
4) Contractionary monetary policy with an expansionary stance.
Let's start with the easy stuff -- both policies pointing in the same direction (expansionary or contractionary). If both fiscal and monetary policy are aimed at the same goal, the result will simply be magnified. For instance, if both the Fed and the federal government are acting in an expansionary manner, we will see an increased supply of money that will lead to increased overall demand and economic output. But if fiscal and monetary policies are pointing in different directions (one contractionary, the other expansionary), then the resulting outcome is harder to forecast.
For instance, let's assume that fiscal policy is expansionary while monetary policy is contractionary. Due to the fiscal policy in place, we will see overall output rise as the government is helping goods to be produced at lower costs, funding social programs more aggressively or increasing citizens' disposable incomes. But if monetary policy is contractionary at the same time, interest rates will rise and demand in the private sector will fall. The higher government spending coupled with lower private-sector demand will cause government spending to account for a larger portion of total national income. The overall result of these opposing trends is tough to predict.
Now let's look at what happens when fiscal policy is contractionary even as monetary policy is expansionary. The private sector will be stimulated, as borrowing is cheaper. So, overall demand will increase. But the public sector, which benefits greatly from government spending, will feel strained. So, that sector's contribution to overall output will decrease. Again, the overall result is very hard to predict due to two policies pointing in opposite directions.
And remember, the scenarios above only cover what's supposed to occur in theory. In reality, it's very hard to predict exactly what the final outcome will be when the two policies contradict one another.
For example, the government might reduce taxes in the hopes of increasing demand. But while the government can directly cut taxes, it can't force citizens to spend their extra disposable income. If people decided to save 100% of the extra disposable income, the expansionary policy would fail to have the desired result.
Another example of desired outcome not being realized can be seen by looking at recent changes to monetary policy. The Fed decided in March to raise interest rates. This seemed likely to send bank stocks higher, as it was assumed financial firms would raise rates on borrowers.
But while the Fed did indeed raise short-term rates, that didn't make 10-year U.S. Treasury yields drop as well. In this instance, the Fed acted, but the market didn't respond in the desired way. The Fed raised short-term rates expecting 10-year yields to follow suit, but that wasn't what happened and bank stocks traded lower.

How These Policies Affect Our Investments

Now that we have a better idea of the effects these policies have, it becomes easier to understand how they affect our investments. Let's use Apple ( AAPL) as an example.
Assume taxes have gone up, which would represent contractionary fiscal policy. Consumers are suddenly left with less disposable income, and a new $700 iPhone feels more expensive, as it's taking up a larger percentage of our disposable income. That leaves us with less money to spend on the things we need like food and rent.
If the iPhone feels more expensive, then fewer people will be willing to upgrade. This results in Apple's revenue decreasing, and as a result, earnings aren't as good as they might have been otherwise.
On the other hand, a expansionary fiscal environment in which taxes have gone down means that buyers suddenly have increased disposable income. That extra cash might entice more consumers to go out and buy new iPhones a bit earlier than they otherwise might have. More people buying iPhones means more revenue for AAPL, and thus a better number for the stock come earnings time.
On the monetary-policy side, increased interest rates mean it's more expensive for companies to grow, as borrowing for expansionary projects becomes more expensive. For example, if Adobe ( ADBE) can't initiate projects it had planned due to higher interest rates, its growth would slow and investors would value the company at a lower multiple. This would lead to increased selling of the stock, which would ultimately push share prices lower.
But the opposite is also true. If the Fed lowers rates, then Adobe could act on projects that wouldn't have been viable in a higher-interest-rate environment. These new projects could allow Adobe to expand more rapidly, thus increasing its overall output. That would lead to higher revenues and potentially to higher earnings (although the increased investments might temporarily strain margins). This increased growth rate would make the company more attractive. Investors might be willing to value it at a higher multiple, pushing the stock higher.

Stay Tuned

We hope this rundown gives members some insight into why it's so important to follow the Federal Reserve, U.S. government spending and the macroeconomic data points that are released each week and can impact both.
Of course, we'll always report on what's moving the market to make sure we keep you up to date. But in keeping with the club format, we also want to constantly teach you the various intricacies that drive our investment strategy.